Edited version of your written advice

Authorisation Number: 1051214948198

Date of Advice: 20 April 2017

Ruling

Subject: Property - subdivision - joint venture - income vs capital

Question 1:

Will the profit on the sale of the subdivided lots be assessable as business income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes.

Question 2:

Will the profit from the sale of the subdivided lots be treated as ordinary income under section 6-5 of the ITAA 1997 as a result of an "isolated transaction" carried out for profit and commercial in character?

Answer:

No.

Question 3

Will the profit on the sale of the subdivided lots be assessable under Parts 3-1 and 3-3 of the ITAA 1997?

Answer:

No.

This ruling applies for the following periods

Income year ending 30 June 2017

Income year ending 30 June 2018

Income year ending 30 June 2019

The scheme commences on

1 July 2016.

Relevant facts and circumstances

You:

● were registered prior to 20 September 1985;

● have an Australian Company Number (ACN);

● are Company Type and Class 'Australian Private Company';

● are limited by shares; and

● are listed as having the Principal Activity of 'Investment Company' in the Australian Securities and Investment Commission (ASIC) company extract details.

Prior to 20 September 1985, a loan of $XX,XXX was advanced to Company A from you to purchase a property (the Property).

The loan was made up of contributions by Person A contributing $XX,XXX, and Persons B and C jointly contributing $XX,XXX.

Around the time of the advancement of the loan, a Bill of Mortgage (the Bill of Mortgage) was entered into by Company A in relation to the loan of $XX,XXX. The Bill of Mortgage included clauses which outlined that the mortgagor was to pay the mortgagee a specified percentage of interest on the principal sum and that the mortgagee could exercise the power of sale and sell the Property.

Company A purchased vacant land (the Property) for $XX,XXX, with the title being registered prior to 20 September 1985.

The Property is vacant land with a land area of less than 10 hectares. It has not been used for any farming, residential or commercial purposes from the time it was acquired until the present time.

Company A failed to make interest payments in relation to the loan soon after the Bill of Mortgage was entered into.

Prior to 20 September 1985, you became mortgagee in possession of the Property as recorded in the notes on the Certificate of Title.

Person A has stated that they have paid the rates, taxes and other expenses arising in relation to the Property since then.

A number of years later, prior to 20 September 1985, Person A states that they paid Person B and C $XX,XXX, being their share of the $XX,XXX loan originally advanced to Company A.

A number of years later the Council resumed part of the Property for use as a road, with no compensation being paid.

Prior to 20 September 1985, Company A was deregistered. At the time it was deregistered, Company A did not have any other assets other than the Property.

The land value of the Property at the time Company A was deregistered was less than the mortgage value.

After 20 September 1985, the Council made an offer to purchase the Property for an amount that was less than the loan and outgoings that had been incurred. The offer was not accepted by you.

A number of years later Person A was appointed as your director.

A number of months later, a Government department issued a letter which confirmed that Company A had been deregistered and that it would not oppose you exercising your power of sale over Company A's assets if the mortgage provided those powers.

A number of years later, the ownership in you was transferred to Person A.

The Council had previously refused to consent to a subdivision due to wetland and drainage issues.

A development application was lodged with the Council, with preliminary approval being granted by the Council subject to conditions.

You took legal action against the Council and lodged an appeal in relation to the preliminary approval that had been granted by the Council. However, the appeal was dismissed. The following information has been sourced from appeal decision:

● you have an interest in the Property;

● you had lodged an application with the Council for preliminary approval to place filling on the land for the purpose of building a detached house, with the proposed house to have frontage to a specified street;

● the Council had requested you to demonstrate why the proposed dwelling could not be located within the portion of the site proposed to be included in the Urban Residential Zone, which was located at the other end of the land, farthest from the esplanade;

● after you had provided further submissions, preliminary approval was granted, subject to conditions

● the appeal had been lodged in relation to the validity of the conditions contained in the preliminary approval, in particular the condition which stipulated where the proposed development could occur on the land

● Company B had entered into a conditional contract to purchase the land. The director of Company B had stated that they wished to build a house at the eastern end of the land. The Council agreed that a house could be built, however it had to be at the western end of the land;

● The land has an area of less than 5 hectares; and

● All of the land is in the Residential A zone.

A number of years after the appeal had been dismissed; the Council issued a Development Application Decision Notice (the Decision Notice) which outlined that the development application for the configuration of the Property into a specified number of subdivided lots, with a specified area being used as open space.

The Decision Notice outlined that a portion of the Property as shown on the Plan of Development would be dedicated to the State with Council as trustee for the purpose of being used for open space and road.

In the following year, the Australian Securities and Investments Commission (ASIC) advised that you held the registered mortgage over the Property which is registered in your name, that you have been the mortgage in possession for some time, and that as previously advised by the Government department a number of years earlier, ASIC did not object to you exercising any rights under the mortgage, including dealing with or selling the mortgaged property.

A number of years later, a Joint Venture Agreement (the Agreement) was entered into between Company B (the Manager) and you as the mortgagee in possession for Person A (the Landowner). The Agreement outlined the following:

● You:

○ would provide the unencumbered Property and would receive $X,XXX,XXX in consideration;

○ pay for council rates and land tax; and

○ will receive a specified percentage of the profits or losses.

● The Manager:

○ will manage and operate the development in accordance with the Agreement;

○ will pay the development costs; and

○ Will receive a specified percentage of the net profit from the development remaining after your consideration, the development costs, and the council rates and land taxes have been paid, or a specified percentage of any losses.

A number of years later, Company B provided the following costing review for the subdivision of the Property:

● Subdivided lots valued between $XXX,XXX to $XXX,XXX

● Total sales - $X,XXX,XXX

● Costs - $X,XXX,XXX

● Land payment to you - $X,XXX,XXX

● Company B's costs - $XXX,XXX

● Net profit - $XXX,XXX.

Company B will organise the marketing and selling of the subdivided vacant lots of land.

The subdivision of the Property is expected to commence in 20XX, with the works anticipated to take a number of months after the Council has approved the works and signs the Plan of Subdivision so that it can be registered at the Land Titles Office in the relevant state.

Based on the costing review provided by Company B, you have estimated that the unsubdivided market value of the Property is $X,XXX,XXX.

The subdivision activities will require the engaging of services of numerous professionals. Quotes have been obtained for most of these activites which totalled $X,XXX,XXX, inclusive of GST, which will be paid by Company B in accordance with the Agreement.

Person A, both in their personal capacity and as your director, will liaise with Company B to facilitate the subdivision of the Property and the selling of the subdivided lots.

Neither you, nor any related parties, have undertaken any subdivision activities or been involved in the business of land development in the past, and do not have any properties that they intend to subdivide in the future.

Assumptions

For the purposes of this ruling decision, the subdivision of the Property will be undertaken in accordance with:

● The Application approved by the Council; and

● The Agreement entered into by you and Company B.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 15-15

Income Tax Assessment Act 1997 Subdivision 70-10(1)

Income Tax Assessment Act 1997 Section 118-20

Reasons for decision

Question 1

Will the profit on the sale of the subdivided lots be assessable as business income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Detailed reasoning

Taxation treatment of property sales

Broadly, there are three ways profits from a land development, subdivision and sale can be treated for taxation purposes:

● As ordinary income as a result of carrying on a business of property development, involving the sale of land and buildings as trading stock;

● As ordinary income as a result of an isolated business transaction entered into by a non-business taxpayer or outside the ordinary course of business of a taxpayer carrying on a business, where the land was acquired or subsequently held for the purpose profit making; or

● As statutory income under the capital gains tax legislation as a result of the sale of a capital asset.

Whether the proceeds are treated as income or capital depends on the situation and circumstances of each particular case.

Change of intention

While holding an asset for a considerable period of time may seem to indicate that it is a long term capital asset, the intention of the taxpayer at the time of acquisition and throughout the ownership period is a crucial aspect.

Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693) (Myer Emporium)is one of the leading cases which shows that the intention at the time of purchasing the asset is an important consideration in determining whether the proceeds received on disposal are on a capital or revenue account. According to the Myer Emporium case, the relevant intention or purpose of the taxpayer is not a subjective test. Rather, it is the intention or purpose as discerned from an objective consideration of the facts and circumstances of the case. Also, if the taxpayer is a company or trust, the courts determine its purposes by looking at the people who control the entity.

Further, the decisions in Casimaty v. Federal Commissioner of Taxation (1997) 97 ATC 5135, 37 ATR 358 and McCorkell v. Federal Commissioner of Taxation 98 ATC 2199; (1998) 39 ATR 1112 demonstrate that if a taxpayer does not intend to make a profit when he or she acquires farming land then the likelihood that any profit made on the eventual sale of land is ordinary income is greatly diminished.

Numerous cases have concerned the assessability of profits or proceeds from the sale of land. The two leading Australian cases dealing with the change of intention and the disposal of capital assets on revenue account are Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation (1950)81 CLR 188 (Scottish Mining case) and Whitfords Beach Pty Ltd v Federal Commissioner of Taxation (1983) 14 ATR 247 (Whitfords Beach). These cases are much relied on in argument in the present case.

It follows from the decisions in Scottish Mining and Whitford's Beach cases that a taxpayer, who had originally acquired property for farming operations purposes, could subsequently embark on a profit making scheme. This means that a taxpayer could embark on a profit making scheme after property was acquired for a different purpose.

Carrying on a business of property development

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the facts.

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

No one indicator is decisive. The indicators must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

Application to your situation

In the context of considering the above authorities and factors when determining whether your activities would be viewed as carrying on of a business, the following general observations of your situation can be made:

● You have been the mortgagee in possession of the Property since prior to 20 September 1985;

● You were advised by a Government department prior to 20 September 1985, and by ASIC after 20 September 1985, that you as the mortgagee in possession could exercise your rights under the mortgage and sell the Property;

● The Council had offered to purchase the Property, but you had refused their offer;

● You have actively sought to be able to subdivide the Property into residential lots, which the Council had refused until preliminary approval, subject to conditions, was granted by the Council;

● You initiated legal proceedings against the Council in relation to the validity of the conditions contained in the preliminary approval, however your appeal was dismissed;

● You lodged a Development Application with the Council a number of years after the appeal had been dismissed, which was approved by the Council for the subdivision of the Property into a specified number of lots with a specified area of the Property to be used as open spaces;

● You have entered into the Agreement in relation to the subdivision of the Property as a joint venture with Company B

● Under the Agreement Company B will receive a specified percentage of the net profits after the payment of following payments made in the following order:

○ payment of $X,XXX,XXX (exclusive of GST) to you for providing the Property

○ reimburse Development costs to Company B, which at the date of the Agreement was $XXX,XXX and reimburse you $XXX,XXX for council rates and land tax;

○ receive a specified percentage of net profits, with you receiving a specified percentage of the net profits; and

○ if a loss occurs, Company B and you will each receive an equal share of the losses.

● Quotes have been obtained from professionals in relation to the completion of the proposed subdivision activities, which totalled $X,XXX,XXX, inclusive of GST, which will be paid by Company B in accordance with the Agreement;

● There is a coherent plan for the subdivision of the Property which is more complex than what would have been involved in the disposal of the Property as vacant land;

● There has been a change in the purpose for which the Property is being held, being a change from vacant land that had not been used for any purpose to subdividing the Property; and

● There has been a change in the nature of the Property with the proposed subdivision transforming the Property from vacant land into a specified number of small residential lots and the remaining portion of the Property to be used as open spaces and road.

A balanced view of these observations, with no one feature being determinative in isolation, reasonably leads to a conclusion the intention for holding the Property has changed upon the commencement of the subdivision of the Property to one of carrying on a business.

You have been the mortgagee in possession of the Property since prior to 20 September 1985, and have not done anything in relation to the Property for many decades.

It has been stated that Person A (your director) is located in a different state to the Property, which has made it difficult to manage the Property.

The simplest way you could have divested yourself of the Property would have been to dispose of it without seeking any subdivision approvals and without actually undertaking the associated works. However, you have not advised us of any period/s that you had put the Property on the market in an attempt to sell the Property as vacant land and the offer the Council made to purchase the Property had not been accepted.

You were advised by the Government department many years after you became the mortgagee in possession, and by ASIC almost ten years later, that you as the mortgage in possession could exercise your rights under the mortgage and sell the Property. However, you have not sold the Property as a whole and have undertaken the subdivision of the Property with the intention of making a profit.

You have actively sought to have the relevant approval for the subdivision of the Property, lodging an application with the Council prior to the appeal, and had provided further submissions at the request of the Council. In the following year, a preliminary approval was granted by Council with conditions. Following the granting of the preliminary approval you had initiated legal action, the appeal, against the Council as you did not agree with the conditions specified in the preliminary approval. The appeal was dismissed.

You lodged a Development Application with the Council a number of years after the appeal had been dismissed, which was approved by Council.

You entered into the Agreement a number of years after the approval of the Development Application for the purpose of undertaking a commercial undertaking in common, being the subdivision of the Property, for the mutual gain of you and Company B.

You have approached the transaction in a businesslike way, by having already or intending to seek advice from professionals and engaging their services to lodge the relevant applications, undertake surveys and investigations, and prepare reports. The inherent nature of the subdivision of the Property is such that it is quite complex given that the process of physically undertaking the subdivision works involves complexities requiring specialist knowledge, the engagement of specialist contractors and the co-ordination of the said parties. While you have engaged third parties to undertake the subdivision activities, this does not preclude you from being in a business.

The estimated costs to subdivide the Property, being $X,XXX,XXX are more than the value of the Property as outlined in the Agreement, being $X,XXX,XXX. The estimated total sales proceeds are $X,XXX,XXX with the net profit of $XXX,XXX, which will be split equally between you and Company B. While you will receive $X,XXX,XXX for providing the Property, the decision to pursue the development of the Property in this manner shows a choice to engage in exposure to risks of the development, including the profits, losses and its general success.

In accordance with TR 97/11, it is viewed that the subdivision of the Property will be a significant commercial activity, and your goal in undertaking the subdivision is to make a profit from the sale of the subdivided lots even though the subdivision will be a “one-off” venture.

Question 2

Will the profit from the sale of the subdivided lots be treated as ordinary income under section 6-5 of the ITAA 1997 as a result of an "isolated transaction" carried out for profit and commercial in character?

Detailed reasoning

Taxation Ruling 92/3 (TR 92/3) states at paragraph 35 that when a taxpayer makes a profit from an isolated transaction other than in the course of carrying on a business, the amount will be income where:

(a) The intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain.

(b) The transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

For a transaction to be characterised as a business operation or commercial transaction, it is sufficient if the transaction is business or commercial in character.

As discussed under question 1, case law has concluded that the mere realisation of a capital asset which was not acquired for the purpose of profit making by sale does not constitute a profit-making undertaking or scheme within meaning of section 15-15 of the ITAA 1997, even though the realisation is effected in the most advantageous manner.

In general, whether a profit from an isolated transaction is income according to ordinary concepts depends very much on the individual circumstances of the case. Matters listed in TR 92/3, which are relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction include:

(a) the nature of the entity undertaking the operation or transaction;

(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;

(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.

Application to your situation

Your activity has the character of a business operation or commercial transaction.

As a result, the profit made on the sale of the subdivided lots will be accounted for on revenue account and will be assessable as business income under section 6-5 of the ITAA 1997 and will not be assessable as an "isolated transaction" carried out for profit.

Question 3

Will the profit on the sale of the subdivided lots be assessable under Parts 3-1 and 3-3 of the ITAA 1997?

Detailed reasoning

Capital gains tax

The capital gains tax (CGT) provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997. Broadly, the provisions include in your assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own.

CGT event A1 under section 104-10 of the ITAA 1997 happens if you dispose a CGT asset. A CGT asset is any kind of property or a legal or equitable right that is not property.

A capital gain will be made if the cost base of the asset is less than the capital proceeds in accordance with section.

Section 118-25 of the ITAA 1997 provides an outright exemption from the capital gains provisions in respect of assets that are trading stock when the CGT event happens.

Application to your situation

After reviewing the facts of your situation and applying the relevant factors set out in TR 97/11, it is the Commissioner's view that the subdivision of the Property and the sale of the subdivided lots will not be a mere realisation of capital assets.

Therefore, as the disposal of the subdivided lots is viewed as a carrying on of a business, any profit made on their sale will be included in your assessable income under section 6-5 of the ITAA 1997 as the sale of trading stock.

However, CGT event A1 will still occur on the disposal of the subdivided lots. Any capital gain made on the disposal of the subdivided lots will be disregarded due to the trading stock exemption.

Further issues for you to consider

The following information is provided as written guidance. A taxpayer who relies on guidance will remain liable for any tax shortfall if the guidance is incorrect or misleading and they make a mistake as a result (unless a time limit imposed by the law precludes the liability). However, they will be protected against the shortfall penalty and interest on the tax shortfall provided they relied on that guidance reasonably and in good faith.

CGT event K4

Subsection 104-220(1) of the ITAA 1997 provides that CGT event K4 occurs if:

(a) You start holding as trading stock a CGT asset you already own but do not hold as trading stock; and

(b) You elect under paragraph 70-30(1)(a) to be treated as having sold the asset for its market value.

Subsection 104-220(2) provides that the time of the event is when you start holding the asset.

CGT event K4 may occur when the property is brought in as trading stock depending on the trading stock election that you make.

Treating the land as trading stock

The meaning of trading stock is given in section 70-10 of the ITAA 1997, and includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business.

Thus a thing can only be trading stock where it is capable of sale or exchange in the ordinary course of a business.

The decision of the High Court in Federal Commission of Taxation v. St Hubert's Island Pty Ltd (in liq) (1978) 138 CLR 210; 78 ATC 4104; (1978) 8 ATR 452 clearly established the principle that land can come within the definition of 'trading stock'. In that case, the High Court determined that land acquired for the purpose of development, subdivision and sale by a taxpayer carrying on a business of property development is trading stock.

The Commissioner's view is set out in Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock'? (TD 92/124). Paragraph 1 of the TD 92/124 states that the 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.

Paragraphs 2 and 3 of TD 92/124 further explain:

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.

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.

Under Subsection 70-30(1) 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

● its cost (as worked out under subsection (3) or (4));

● its market value just before it became trading stock; and

(b) you had immediately bought it back for the same amount.

When you must make the election

Under Subsection 70-30(2) you must make the election by the time you lodge your income tax return for the income year in which you start holding the item as trading stock.

However, if you do not make the election by then because you do not realise until a later date that you started to hold the item as trading stock, you must make the election as soon as is reasonable after realising that. Otherwise, you can request the Commissioner to exercise his discretion to allow you to make a late election.

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