Edited version of your written advice

Authorisation Number: 1051262048627

Date of advice: 4 August 2017

Ruling

Subject: Property – subdivision - Am I in business? – profit making undertaking – realisation of a capital asset

Question 1:

Will the profit from the sale of the subdivided lots be treated as ordinary income under section 6 -5 of the Income Tax Assessment Act 1997 (ITAA 1997) as a result of carrying on a business of property development?

Answer:

No.

Question 2:

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

Answer:

Yes.

Question 3:

Will the profit from the sale of the subdivided lots be treated as statutory income under the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997 as a result of a realisation of a capital asset?

Answer:

Yes. However, section 118-20 of the ITAA 1997 will apply to reduce the capital gain to the extent that the profit from the sale of the subdivided lots is otherwise included as assessable income under section 6-5 of the ITAA 1997.

This ruling applies for the following periods

Income year ending 30 June 2018

Income year ending 30 June 2019

The scheme commences on

1 July 2017.

Relevant facts and circumstances

After 20 September 1985, a development application was lodged with the local council (the Council) with an amended plan being lodged at a later date.

The Council approved the development application (DA) of the Property into a specified number of subdivided lots.

A number of years after the DA was approved a continuance of the DA was issued by the Council.

A number of years later a plan of the proposed subdivision of the Property into the specified number of subdivided lots was prepared.

Company A was registered prior to the continuance of the DA being issued by the Council. Person A is one of the directors of Company A.

Company A entered into a contract to purchase the Property a number of years after the continuance of the DA had been issued, with settlement occurring a number of months later.

In the following year, Company A’s board of directors approved the sale of the Property and the Property was listed for sale with a real estate agent.

A Valuation Certificate for the Property was obtained a number of months after the decision had been made to put the Property on the market from which the following information has been sourced

● the Property is located approximately XXX kilometres from a capital city, XX kilometres from a small town and XX kilometres from a rural city;

● there is a decreasing number of large rural grazing properties in the local area, with an increasing number of rural residential lots typically less than 50 hectares;

● the Property has a land area of less than 200 hectares which consisted of predominantly fragile and erodible soil, with more than half of the Property being cleared and suitable for light grazing purposes. The Property had limited agricultural capability or potential even if significant investment was allocated to pasture improvement;

● access to the Property is via an unsealed partly formed Crown roadway reserve

● the current zoning of the Property is single rural residential use under RU2 Rural Landscape;

● due to the extensive costs involved in providing sufficient services to any subdivision of the Property, it was viewed that that type of development was uneconomical due to the costs in addition to the slow market. The existing recreational/lifestyle use of the Property was considered to be the highest and best use of the Property at that time;

● the Property was listed for sale with a local real estate agent for $XXX,XXX, which was considered too high, restricting buyer interest and potential offers with the market for this type of property being slow and limited; and

● the current market value of the Property was assessed as being $XXX,XXX, with a value of $XXX,XXX to be adopted.

The contract with the real estate agent to sell the Property ended the following month.

During Company A’s board of directors meetings over the following months it was determined that the sale price of the Property would be reduced. Additionally, as a result of no offers having been received when the Property had been listed with the real estate agent, a number of the directors had put in an offer to purchase the Property.

A second Valuation Certificate for the Property was obtained during the following year from which the following information has been sourced:

● the market for this type of property had fallen with the market for this type of property being slow and limited, while there was reasonable demand available for rural lifestyle properties less than 50 hectares in size;

● the Property was listed for sale with a local real estate agent for $,XXX,XXX, which was reduced until recently at offers over $XXX,XXX. Minimal interest in the Property had been expressed even in view of the price reduction;

● the asking price was considered to still be too high and that in the present market that the Property should be advertised at $XXX,XXX, with an estimated selling price in the range of $XXX,XXX to $XXX,XXX; and

● the current market value of the Property was assessed as being $XXX,XXX with a value of $XXX,XXX to be adopted.

During the same month a meeting of the board of directors of Company A was held when discussions about the current value of the Property and the purchase of the Property by some of the directors, with Person C becoming a partner in the Property.

The directors could not source the finance to purchase the Property and the sale of the Property to the directors did not proceed.

Person B and Person C wanted to purchase the Property with Person D. However, they could not afford to purchase the Property.

Person A and Person B are the parents of Person C and Person D is a friend of Person B and also has dealings with Person C.

A number of months after the Company A meeting, a letter was sent from a bank advising that they had approved a specified amount to Person A, Person B, Person C and Person D.

In the same month, Person B, Person C and Person D entered into a contract to purchase the Property, with settlement occurring during the following month.

The Property was zoned R2 Low Density Residential and is located a number of hours away from Person B and Person C’s main residence.

In the same month settlement occurred on the purchase of the Property, Person D was married.

During the following year a vehicle was purchased.

During the following year the bank approved a further amount of borrowings to Person A, Person B, Person C and Person D with the Property being registered as security for the loan.

No farming activity was undertaken on the Property with the exception of buying a tractor and maintaining the Property. The Property has been used extensively by Person B, Person C and Person D, and extended families and friends, for weekend and holiday escapes from their city lifestyles. It has also been used as a retreat by a specified organisation.

A number of months after the second loan had been obtained, Person D advised that they were going to cease their full time employment due to personal reasons and as a result would not be able to contribute to the mortgage payments. They had expressed that they wanted to sell the Property and/or receive a return on their share of the Property.

During the following month, real estate agent/s were approached for a valuation of the Property.

The Property on the market after obtaining the valuations from the local real estate agent/s who had advised that the market value of the Property was between the mid to high $XXX,XXX range.

An agent advised that the return on the sale of the Property would be better if the Property was sold as subdivided lots if the development costs could be covered because the subdivided lots would be easier to sell given that they would be of a smaller acreage and bank loans would be easier to obtain by potential buyers.

A decision was made to subdivide the Property into a specified number of proposed lots, with Person B and Person C keeping one of the lots and the other proposed subdivided lots to be sold (the Sale Lots).

In the following month a government organisation advised that the land valuation of the Property was $XXX,XXX.

During the following months, the services of Company B were engaged in relation to the subdivision of the Property.

Over a number of months quotations were received from various entities in activities arising in relation to the subdivision of the Property.

During the following months an application for the Subdivision Construction Certificate was lodged with, and issued by Council.

The Property will be subdivided into a specified number of lots, ranging in sizes of less than 150 acres, with the Sale Lots to be sold by a real estate agent (the Project) in accordance with the DA.

The subdivision activities will include construction of road, fencing, power installation to all blocks and land clearing.

The cost to subdivide the Property is estimated to be $XXX, XXX, which includes the amounts included in the quotes, GST costs estimated to be around $XXX, XXX, legal/solicitors costs, council costs and fees, sales commissions/marketing and sundry costs.

The estimated sales prices of the proposed subdivided lots will vary.

The value of the proposed lots is estimated to be around $X million which will be reduced by the bank mortgage of $XXX,XXX and subdivision costs estimated to be $XXX,XXX, leaving a gain of $XXX,XXX to be split between Person B, Person C and Person D which would equate to each party getting a return of $XXX,XXX.

It is anticipated that the subdivision activities will commence in mid to late 2017, with the sales of the subdivided lots expected to occur in the 2017-18 and 2018-19 income years.

Person B, Person C and Person D will take an active part in the negotiations and management of the subdivision activities including management and liaising with consultants, contractors, council, agents and legal advisors.

Person B, Person C and Person D do not have any previous involvement either directly or indirectly in any subdivision or development of any real estate or properties.

Neither Person B or Person C, nor any related entities, intend to undertake any similar activities in the future.

The Project will be funded by Person B, Person C and Person D, with assets having been sold, or will be sold, with the proceeds being used in relation to the Project. Additionally, savings will be accessed and Person A will contribute monies from their superannuation to fund the commencement of the Project. A loan may be sourced to complete the development if required, however at this point no loan application has been made, nor needed to commence the Project.

Person B and Person C are not registered as a business and have not obtained an Australian Business Number.

Relevant legislation provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Reasons for decision

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 on revenue account, as a result of carrying on a business of property development, involving the sale of land and buildings as trading stock;

● as ordinary income on revenue account, 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 on the basis that a realisation of a capital asset has occurred.

The 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.

Numerous cases have considered the assessability of profits or proceeds from the sale of land including the following cases:

Whitfords Beach Pty Ltd v Federal Commissioner of Taxation (1983) 14 ATR 247 where the taxpayer acquired 1.584 acres of land for non- commercial purposes. Thirteen years later, the original shareholders sold out and the company and the new ownership adopted an entirely new set of articles. It then embarked on a long and complex course of activity which involved the land being rezoned and developed as a residential subdivision. Vacant lots were sold over a period of many years for a substantial profit. The High Court held that the adoption of a new set of articles resulted in a change in the intended usage of the land. This resulted in the taxpayer’s activities going beyond the realisation of a capital asset, with the activities constituting the carrying on of an actual business of subdividing and selling land.

Statham & Anor v. FC of T 89 ATC 4070 20 ATR 228 (Statham’s case) where the property was subdivided and sold after a business of raising cattle had failed. The taxpayer relied on the local council to carry out the subdivision work and the local real estate agents handled the advertising and sale of the lots. The Full Federal Court held that what occurred was the realisation, by the most advantageous means, of the asset which the owners had on their hands when they abandoned the intention of farming the subject property.

Casimaty v FC of T 97 ATC 5135; (1997) 37 ATR 358 (Casimaty's case) where due to the growing debt and the ill health of the taxpayer, primary production land was progressively subdivided and sold off over a period of 18 years. There was no coherent plan conceived for the subdivision of the whole property. The taxpayer had acquired and had continued to hold and use the residence and conduct the business of a primary producer on the property. Therefore, there was no change of purpose of object for which the property had been held. In his judgment, Ryan J in the Federal Court held that the profits resulted from the mere realisation of a capital asset and as such the profits were not assessable as ordinary income.

Stevenson v. Federal Commissioner of Taxation (1991) 29 FCR 282 91 ATC 4476 22 ATR 56 (Stevenson case) where taxpayer had owned farming land for many years, selling a portion of the land to a third party to be used for agricultural purposes. In early the 1970’s he decided to scale back his farming activities and sell most of the remaining 90 acres, other than a few acres retained for his use. He could not source a developer who would pay his sale price and in 1976 he determined that he would subdivide the land himself. He commenced subdividing the land in stages, obtaining finance and personally arranging for the construction of the necessary earthworks, storm water drains, guttered road works and other improvements to the land. Around the same time his farming income consisted of mainly agistment income. Throughout the process the taxpayer had personally dealt with councils, engineers, and statutory utilities. He advertised the development himself, did not engage the services of any particular real estate agent to assist him, dealt personally with prospective purchasers, did some of the physical work himself and fixed the sale price for the subdivided lots, being 220 lots. It was held that the taxpayer was carrying on a business of developing land.

As displayed in the above cases, a taxpayer can embark on a profit making scheme or the carrying on of a business after property was acquired for a different purpose.

We will consider whether the Project will be viewed as the carrying on of a business, the undertaking a profit making activity or the realising a capital asset when the Property is subdivided and the Sale Lots are sold as follows:

Carrying on a business of property development

Section 995 of the ITAA 1997 states the term 'business’ includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

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 particular 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. In the Commissioner’s view, the factors that are considered important in determining the question of business activity 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.

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

Application to your situation

Person B, Person C and Person D purchased the Property and have now made the decision to subdivide the Property and sell the Sale Lots, with Person B and Person C to keep one of the proposed subdivided lots.

In the ruling it is stated that:

● Person A as included on the bank loan because Person B, Person C and Person D did not have enough security or income serviceability to obtain the bank loan given that the Property was zoned rural;

● Person A did not want to be included on the title of the Property as they have an investment property and would be subject to land tax;

● Person B, Person C and Person D had wanted to purchase the Property for differing reasons ranging from long term family investment, primary production purposes, to assist in specific aide material and for retreat/hobby farm purposes;

● the Property had been purchased to conduct small scale stock and crop operations. Since the Property was purchased some spraying and paddock clearing, building improvements and upgrades, and fencing had been undertaken. A tractor, grader, slasher, rotary hoe and backhoe have been purchased for improving the pastures on the Property;

● a small number of stock was purchased for the commencement of stock breeding activities;

● the farming operations did not reach a commercial level of operation due to the size and poor condition of the existing infrastructure, such as fencing, and issues with kangaroos on the property;

● Person B and Person C are not in a financial situation to be able to purchase Person D’s share in the property;

● Person D was not happy with a sale of the whole Property due to the small return they would receive for their share in the Property and consideration had been given about how the Property should be sold given that if the Property was sold at the valuation price, Person D would have only received a small return taking into consideration the mortgage repayments, selling costs and tax payments;

● it was suggested that to maximise the profit from the sale of the Property that it should be subdivided into a specified number of subdivided lots and sold off separately. Additionally, due to bank lending practices it would be easier to find potential buyers of smaller lots rather than a large parcel of land;

● it was determined that the subdivision of the Property would give Person D a much healthier return on their original purchase and all parties agreed that this would be a better option;

● Person B is hoping to retire from full time work and is wanting to retain one of the subdivided lots to continue enjoying a lifestyle property close to their city residence, in conjunction with Person C;

● the adjoining property owner had put in a bid to purchase the Crown land on which the on kilometre access road to the Property is located, without success; and

● as part of the subdivision, the road on the Crown land will be sealed by the purchasers of the subdivided lots and will be returned to the Crown for future management and ownership.

In this case Person B and Person C have not previously undertaken any similar subdivision activities in the past and do not have any intention to undertake any similar activities in the future.

Person A, Person B, Person C and Person D will fund the subdivision activities and will take an active part in the management of the subdivision activities and will engage the services of a real estate agent/s to sell the subdivided lots, the Sale Lots.

After reviewing the information and documentation provided, it is the Commissioner’s view that the activities arising in relation to the Project are not those of an entity carrying on a business of developing and selling property.

While Person B, Person C and Person D are undertaking some of the activities in relation to the Project, they are not of the level or scale as those undertaken by the taxpayer in the Stevenson case.

Additionally, the activities undertaken do not display the salient indicator of a business, which are transactions entered into on a continuous and repetitive basis. This is a small, one off project that is not being carried out in a manner similar to other property development businesses.

Therefore, any profit made on the disposal of the Sale Lots will not be assessable as ordinary income from the carrying on of a business.

We will consider whether or not the profits from the sale of the Sale Lots will be viewed as being received in relation to a profit making undertaking or a realisation of a capital asset as follows:

Isolated business transactions

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

Taxation Ruling TR 92/3 (TR 92/3) considers the principles outlined in Myer Emporium and provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 as ordinary income.

Paragraph 1 of TR 92/3 outlines that isolated transactions are:

a) those transactions outside the ordinary course of business of a taxpayer carrying on a business; and

b) those transactions entered into by non-business taxpayers.

TR 92/3 outlines that the relevant intention or purpose of the taxpayer, of making a profit or gain, is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer’s intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

Paragraph 13 of TR 92/3 outlines the following factors which may be relevant when considering whether an isolated transaction amounts to a business operation or commercial transaction:

● the nature of the entity undertaking the operation or transaction;

● the nature and scale of other activities undertaken by the taxpayer;

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

● the nature, scale and complexity of the operation or transaction;

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

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

● if the transaction involves the acquisition and disposal of property, the nature of the property, and

● the timing of the transaction or the various steps in the transaction.

If a transaction or operation is outside the ordinary course of a taxpayer’s business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question.

Paragraphs 41 and 42 of TR 92/3 outline that where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction, the activity of the taxpayer constitutes the carrying on of a business operation or commercial transaction carrying out a profit-making scheme, as the case may be.

In addition to the above factors, for the purposes of determining whether the activities undertaken in relation to real property and development equate to a profit-making undertaking or scheme, Miscellaneous Taxation Ruling MT 2006/1 (MT 2006/1) aligns itself with TR 92/3 and provides a list of factors which, if present may be an indication that a business or profit-making undertaking or scheme is being carried on.

In determining whether activities relating to isolated transactions are a profit making undertaking or are the realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. This may require a consideration of the factors outlined above; however there may also be other relevant factors that need to be weighed up as part of the process of reaching an overall conclusion. No single factor will be determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities.

In the context of considering the above authorities and factors when determining whether the Project would be viewed as a profit making undertaking, the following general observations have been made:

● there is a coherent plan for the subdivision of the Property into a specified number of proposed subdivided lots which is more complex than what would have been involved in the disposal of the Property as broad acres. The simplest way the Property could have been divested would have been to dispose of it as a whole property, potentially for a reduced price;

● a decision has been made to subdivide the whole property unlike the taxpayer in the Casimaty case who subdivided their property in pieces and had never contemplated subdividing the whole property;

● there has been a change in the nature of the Property with the proposed subdivision transforming the property from broad acres into smaller rural lots for hobby/lifestyle purposes;

● neither Person B or Person C, or any related entities have been involved in similar activities in the past and do not have any plans to undertake any similar activities in the future.

● the market value of the Property unsubdivided was estimated to be in the high $XXX,XXXs with the subdivision costs estimated to be $XXX,XXX. Based on those figures, the cost to subdivide the property will be around one and a half times the market value of the unsubdivided value of the Property;

● the proceeds from the Sale Lots is estimated to be $X million, however Person B and Person C intend keeping one of the subdivided lots yet to be determined. Depending on which subdivided lot is kept by Person B and Person C, the value of the unsubdivided Property will be around a third of the expected proceeds;

● there is a demonstrated intention to profit from the subdivision of the Property and the transaction has been undertaken in a commercial manner.

● Person B, Person C and Person D, in addition to Person A, are funding the subdivision of the Property and at this point do not have any intention to source any borrowed funding; and

● Person B, Person C and Person D will manage the subdivision activities and will engage the services of a real estate agent/s to sell the Sale Lots.

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 activities to a profit making undertaking.

The intention in relation to the Property changed when the parties committed to this one-off undertaking in relation to the subdivision of the Property and the proposed sale of the Sale Lots. The decision to pursue the subdivision shows the parties choice to engage in exposure to the risks of the development, including the profits, losses and its general success for the purpose of maximising the potential profit made on the sale of the Sale Lots.

Person B, Person C and Person C will fund the subdivision and will manage the Project. Therefore, they are incurring the risks involved with the subdivision and will have control of the subdivision activities. However, as outlined above, the facts of this situation are not the same as those of the taxpayer in the Stevenson case.

This situation is also not like the Casimaty case as it is the plan to subdivide the whole property as opposed to the piecemeal subdivision of the property undertaken in that case. Additionally, this situation is not the same as the Statham case where the council had undertaken all of the work relating to the subdivision of the property as the parties are managing the Project and will engage the services of the relevant entities to undertake the activities arising in relation to the Project.

It is viewed that the subdivision activity is of a sufficient scale to characterise it as a commercial or profit-making undertaking.

We have determined that based on the facts of this situation that the Project will be a profit making undertaking and the profits from the sale of the Sale Lots will be considered to be ordinary income and will be assessable under section 6-5 of the ITAA 1997.

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.

Section 118-20 of the ITA 1997 contains anti-overlap provisions which operate to reduce any capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 as a result of the sale.

Making an overall assessment on the factors set out in TR 92/3, it is the Commissioner’s view that the subdivision and sale of the Sale Lots will not be a realisation of capital assets. Therefore, as the disposal of the Sale Lots is viewed as an isolated transaction, any profit made on their sale will be included in your assessable income under section 6-5 of the ITAA 1997.

Application to your situation

CGT event A1 will occur in relation to both Person B and Person C on the disposal of their ownership in each of the Sale Lots. The capital gain for the CGT event is worked out by comparing the cost base of their ownership interest in the asset with the capital proceeds for its disposal. If the conditions under Division 115 of the ITAA 1997 are met, the capital gain can be reduced by 50% by applying the CGT discount.

Any capital gain made on the disposal of the Sale Lots will be reduced to the extent that the profit from the sale of the Sale Lots is included in Person B and Person C’s assessable income under section 6-5 of the ITAA 1997.

The capital gain amount will be reduced by the amount included in Person B and Person C’s assessable income under section 6-5 of the ITAA 1997 to avoid double taxation.

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