Edited version of your written advice

Authorisation Number: 1051268314606

Date of advice: 15 August 2017

Ruling

Subject: Land as trading stock

Question 1

Will any profit on the sale of the property be assessable under Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) and any loss deductible under Section 8-1 of the ITAA 1997?

Answer

Yes.

Question 2

If the answer to question one is in the negative, is the sale a mere realisation of a capital asset and taxable on capital account under the capital gains tax (CGT) provisions?

Answer

Not necessary to answer this question.

This ruling applies for the following period:

Year ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

1. A Pty Limited (the A Trustee) is trustee of the A Unit Trust (A Unit Trust).

2. The directors of the Trustee, X and Z, have been involved in numerous property developments for the majority of their working life. They have also been directors of a number of property development entities.

3. The shareholder of the A Trustee is B Pty Limited (Trustee B) as Trustee for the B Unit Trust (B Unit Trust).

4. The A Trust was established with the said intention of purchasing and developing property into industrial allotments for sale, however there was no business plan.

5. The unitholder of the A Unit Trust is B Trustee.

6. The directors of the B Trustee are X, Z and Y.

7. The A Trustee acquired option agreements (with staggered expiry dates) to purchase three adjacent lots of property, Lots 1, 2 and 3 (The Property).

8. Under the options agreements the A Trustee must pay annual option fees to retain its rights and those fees are credited against the purchase price at settlement. Option fees are treated as expenses of the B Unit Trust.

9. At the time that the option agreements were entered into, all the lots were unimproved, other than livestock fencing and pasture. They were being used for the agistment of cattle.

10. The Property forms part of a larger development proposal which includes Lot 4. Lot 4 is being developed by a related entity, D Pty Limited through a development management agreement with the landowner.

11. X and Z are also directors of D Pty Limited.

12. Entities controlled by X and Z have been involved in the project since 2005 and have incurred significant expenditure. In view of the work undertaken and expenditure incurred, entities associated with X and Z were subsequently issued units in the B Unit Trust at no cost.

13. The B Trust will receive 100% of the profits from development of the Property and 50% of the profits from the development of Lot 4.

14. C Pty Limited lodged a development application seeking preliminary approval to vary the effect of the Planning Scheme for industrial development. The development application related to the Property and Lot 4.

15. The directors of C Pty Limited are X and Z.

16. C Pty Limited and E Pty Limited have been engaged as Project Managers for the Development. You have provided a copy of the Project Management Agreement, whereby C Pty Limited Management was engaged by the A Trustee as the Project Manager for the Property.

17. The Project Manager began consulting with various real estate companies with expertise in industrial sales and leasing. The general advice from these agencies was to delay development due to over-supply and lack of demand in the industrial market.

18. The Development has been advertised for sale for several years.

19. There have been no sales of the Property to date.

20. B Trustee entered into a loan agreement with A Trustee. The loan was unsecured. The loan agreement does not set out the normal interest rate, only the default interest rate.

21. The first Information Memorandum (the First Memorandum) was issued by the B Trust in order to raise capital. The investment strategy of the B Trust was to provide funding to the A Trustee and D Pty Limited.

22. The Project Manager a real estate agent to market the proposed subdivided industrial lots. A large sign was erected and the Property listed for sale on the internet. Lots are currently listed for lease.

23. The Council gave preliminary approval to vary the effect of the Planning Scheme use rights for industrial development.

24. The second Information Memorandum (the Second Memorandum) was issued by the B Trust in order to raise further capital.

25. The Project Manager undertook further consultations with the real estate agent. The advice was that the market value of the property of Lot 1 was likely to be less than the contract price payable by the A Trustee.

26. Despite this advice, the A Trustee exercised the option and completed the purchase of Lot 1. It was a special condition of the contract of sale that there would be an agistment lease to the vendor.

27. The A Trustee borrowed additional money from a third party via a secured by a mortgage and unlimited guarantees by the B Trustee and D Pty Limited.

28. The Project Manager formed the view that there was a large oversupply of industrial land competing with the Property. The Project Manager advised the A Trustee to seek an approval for a mixed-use (residential, commercial and industrial) development of the Property. The strategy was designed to achieve a higher value for the land primarily through the allocation of a major portion of the Property for residential use. The A Trustee instructed the Project Manager to prepare applications to change the designation of the Property from industrial to mixed use.

29. The third Information Memorandum (the Third Memorandum) was issued by the B Trust in order to raise further capital.

30. Units in the B Trust are held by X and Z through associated entities and independent investors. X and Z related entities currently hold XX% of the issued units. Entities associated with E, the controller of E Pty Limited, hold an additional X%

31. The land remains as vacant rural land, used for cattle agistment

32. The A Trustee has entered into a call option agreement over nearby land. Option payments are to be made at 6, 12 and 24 months from the date of the option agreement.

33. The A Trustee is seeking further properties in the area for long term hold.

34. The A Trustee has lodged Trust income tax returns in respect of its business. The main business activity has been disclosed as that of 'Land development or subdivision.’

35. Holding costs associated with the Property have been claimed as an income tax deduction when incurred. Acquisition costs including incidental costs of acquisition and development costs have been taken up as 'cost of goods sold’ and reflected in the closing stock of the accounts and income tax returns.

36. As at 30 June 2016, the A Trustee had carried forward income tax losses associated with the development.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 70-5 of the Income Tax Assessment Act 1997

Section 70-10 of the Income Tax Assessment Act 1997

Section 100-30 of the Income Tax Assessment Act 1997

Section 102-5 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Section 118-25 of the Income Tax Assessment Act 1997

ATO view documents

Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock’?

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production?

Case law

Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (1978) 138 CLR 210

R & D Holdings Pty Ltd v Deputy Federal Commissioner of Taxation 2006 ATC 4472

John v Federal Commissioner of Taxation (1989) 166 CLR 417

London Australia Investment Co Ltd v FCT (1977) 138 CLR 106

GRE insurance Limited v FCT; Unitraders Investments Pty Ltd v FCT 92 ATC 4089.

AGC (Investments) Limited v FCT 91 ATC 4180

Grollo Nominees Pty Ltd v FC of T 97 ATC 4585

Western Gold Mines NL v Commissioner of Taxation (WA) (1938) 59 CLR 729

Reasons for decision

Summary

Lots 1, 2 and 3 are trading stock.

Detailed reasoning

Generally, the proceeds from the sale of land will be taxed in one of three ways:

(1) As ordinary income, where the land is held as trading stock and sold as part of a business;

(2) As ordinary income, where the land is not trading stock and is sold as part of an isolated profit making scheme or undertaking; or

(3) On capital account, where the proceeds of sale are a mere realisation of a capital asset.

Trading stock

Subsection 70-10(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that trading stock includes:

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

(b) livestock

The High Court has accepted that land can be trading stock (see Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (1978) 138 CLR 210 which considered the meaning of “trading stock” in the Income Tax Assessment Act 1936 (ITAA 1936)).

The Commissioners view on when land is trading stock is provided in Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock’?, which provides:

1. Land is treated as trading stock for income tax purposes if:

a. it is held for the purpose of resale; and

b. A business activity which involves dealing in land has commenced.

2. Both the required purpose and the business activity must be present before land is treated as trading stock…

Held for the purpose of sale

Land can only be treated as trading stock if it is held for the purposes of resale. This issue was discussed by Finn J in R & D Holdings Pty Ltd v Deputy Federal Commissioner of Taxation 2006 ATC 4472. After identifying Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (1978) 138 CLR 210 (the St Hubert’s Island case) as the seminal case on whether land can be trading stock, Finn J made the following comments about the decision in St Hubert’s Island (at 4480):

46. The significance of this case for present purposes is that it is authority for the propositions that (i) land acquired for the purpose of development, subdivision (or strata division) and sale by allotments (or lots) can constitute trading stock of a business having that purpose irrespective of whether the land has been so developed and subdivided; and (ii) that business will be carried on for so long as the taxpayer engaged in the effectuation of the purpose of development, etc of the land. The emphasis in St Hubert’s Island on the need to have the relevant intention of sale at the time of acquisition of the property in question is, though’ without significance for s 70-10 purposes which as I have earlier noted links the intention or purpose of sale with the purpose (or purposes) for which the property is held. (emphasis in the original)

Finn J went on to discuss the High Court decision in John v Federal Commissioner of Taxation (1989) 166 CLR 417, which also considered the meaning of “trading stock” in the 1936 Act, and made the following comments about purpose (at 4481):

50. …, there is one aspect of John which is of present assistance. It was indicated in the joint judgement (at 430) that the s 6(1) definition of “trading stock was predicated on the prescribed purpose (i.e. of manufacture, sale or exchange) attending the acquisition of the item in question”. However, it was indicated that the definition did not require that the relevant purpose be the sole or dominant purpose”. I can see no reason why a like view should not be taken to the like purpose requirement for which the relevant property is held in the s 70-10 definition of the 1997 Act. The significance of this for present purposes is that I have found below that R & D Holdings held the Bulletin Place property at the relevant time for the dual purposes of sale or lease of subdivided lots. These two purposes clearly are not “contrary or inconsistent”…

To be “trading stock”, land must be held for the purpose of development and sale, but the purpose of sale need not be the main purpose for the holding of the land. Generally, where a developer does not own or hold land they cannot apply the trading-stock provisions.

For the purposes of section 6-5 of the ITAA 1997, where a taxpayer carries on a business, it is unnecessary to establish purpose in relation to the individual transactions comprised by that business. This is because:-

● Profits or gains made in the ordinary course of that business are invested with a profit making purpose

● Profits which arise as an ordinary incident of a business are invested with a profit making purpose.

Therefore land will be held for the purpose of sale where the sale of land is a normal operation in the course of carrying on a business.

This well settled principle of law was re-affirmed by the Full High Court in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106 (London Australia). In that case the court expressed the view that Californian Copper, and the many cases which have relied upon it, established the principle that profit from a sale carried out in the course of a business is income according to ordinary concepts. In particular Jacobs J stated (at 127-128):

It may first be stated that the activity of the taxpayer must be identified as a business activity. If, otherwise than as part of a business of so doing, a man purchases a particular item of property primarily in order to enjoy it in specie or to enjoy the income from it, but at the same time expecting and intending that he will at some time in the future, if and when an opportune occasion presents itself, sell the item of property at a profit, the profit will not be taxable under the first limb of s26 (a). But if the dominant purpose is that of sale, then it will be.

If the acquisition and disposal of property is part of a business of so doing, the position is significantly different. There must still be a purpose of resale because resale is part of the description of the relevant business, and, since business has in it the notion of profit-making rather than loss-making, there must not be a sole purpose or the primary or dominant purpose, as is the case under the first limb of s.26 (a). It need only be one of the purposes. And in this context the word “purpose” is hardly if at all distinguishable from intention or expectation. The dominant or primary purpose may be to obtain income from the items of property acquire but if there is a purpose or intention or expectation of selling at a profit if and when a suitable occasion arises then one condition of carrying on a business of buying and selling at a profit is satisfied. If a man makes a business of acquiring property with a dual purpose of enjoying it or its profits and of reselling it eventually at a higher price than he paid for it, then not only the income from the property but also the profit on resale will be income in the ordinary sense of the term, and within the second limb of s26 (a).

It is therefore essential to identify what the business in question comprises so that it can be determined whether a sale of property was a business operation carried out in the course of a business of profit making or a mere realisation of a capital asset. This principal, discussed in Western Gold Mines NL v Commissioner of Taxation (WA) (1938) 59 CLR 72 and re-affirmed in London Australia requires the Commissioner "to make both a wide survey and an exact scrutiny of the taxpayer's activities" (at 116). Therefore, it is not only the particular activities of the taxpayer entity that are relevant, but the entire group involved in the property development.

This principle of examining the entire context in which the transaction(s) took place is discussed in GRE insurance Limited v FCT; Unitraders Investments Pty Ltd v FCT 92 ATC 4089. In that case, the Full Federal Court (Northrop, Davies and Jenkinson JJ ) held that the profits made by Unitraders, a subsidiary of GRE, on disposal of securities it had acquired from GRE, were assessable under subsection 25(1) of the ITAA 1936 (the 1936 Act’s equivalent of section 6-5 of the ITAA 1997) because the activities of Unittraders were part of the business in which its parent company was involved.

In reaching their decision the Court reasoned that “…the activities of Unitraders were an integral part of the insurance business conducted by GRE (at 4093). The Court went on to state at pp 4094-95:

That is not to say that Unitraders should not be considered as a taxpayer in its own right. It was such a taxpayer and its activities should be so considered. Nevertheless, the part which a subsidiary plays in affairs which concern its holding company, or in the group in which both companies form a part, may throw light upon the character of the activities of the subsidiary. …In the present case, Unitraders was introduced into the affairs of GRE solely to ensure that the benefit of the s. 46 rebate would not be lost in the event that underwriting losses brought GRE to the position that it had no taxable income. Unitraders was a separate entity from GRE but its activities reflected, indeed formed part of, the overall business in which GRE was engaged

It is therefore clear that when characterising the profit or loss made by a company, trust or other entity in an economic group, the part that an individual entity plays in the wider activities of the group is a relevant consideration. If the facts establish that a single business is being carried on by one or more related entities then the activities of each entity partake of a business character. Where profits from the disposal of assets ordinarily arise in the course of the broader group business, or where such profits are an ordinary incident of the carrying on of that business, then there is no need to establish a purpose of profit making by sale at the individual entity level. The requisite purpose is inferred from the part that the individual entity plays in the broader group business. This principle finds support in the decision of Grollo Nominees Pty Ltd v FC of T 97 ATC 4585, where the full Court of the Federal Court decided that it would not be correct to treat a single purpose entity's activities in isolation of those of the remainder of the Group. They said at 4633-4635:

The solution to the problem lies in the correct characterisation of the moneys which came to Grollo Australia's credit to enable it to carry out the building work.

…

The starting point for a consideration of the problem here is the fact that Grollo Australia was one of the Grollo Group of companies. The Group carried on business as substantial builders of commercial and industrial buildings. Over the years it had also engaged in construction work for public authorities. It had been in business for over ten years,that is at the time these transactions were entered into. Grollo Australia was a new member of the Group. It was the vehicle which was used for this project. It was the joint venturer for the Grollo interests and it entered into the arrangements with the other joint venturer, St Martins. Originally, it was not intended to be the builder; the builder was to be Grofam. It was only when problems were encountered as a consequence of that being the case that the structure of the arrangement was changed so that Grollo Australia became, at least nominally, the builder employing Grofam as a sub-builder to carry out the building work involved in the project.

…

Grollo Australia, at least up to the stage of this project, had not been engaged in the building industry in the sense of having carried out other building projects as had Grofam. But it would not be correct to treat its activities in isolation of those of the remainder of the Group. It was part of a group which was regularly carrying out building projects, whether for the Grollos themselves or for other persons. It is true that the project in question was very large and was probably the largest project which the Group had on hand during the years of construction which began in 1981. But it was, nevertheless, but one more project.

In formulating a decision in this case as to the correct characterisation of a future sale of the Property, either in individual lots or on an englobo basis, it is necessary to consider the role that the A Trustee plays in the wider activities of the group. To this end it is necessary to consider the controlling individuals of the group within which the A Trust sits. In this case, the controlling minds of the group are X and Z. They are also the controlling minds of the A Trust. Both directors have been involved in numerous property developments for the majority of their working life. They have also been directors of a number of property development entities. As outlined in the facts, the directors, through D Pty Limited, the A Trust, the B Trust and C Pty Limited have been extensively involved in the acquisition and development of the Property and Lot 4. The two directors of the A Trustee, the land owner, are also directors of the B Trustee, the unit holder of the B Trust. The B Trustee also provided finance to the A Trustee to finance the purchase of one lot, continue option payments on the other lots and to cover ongoing development expenses. X and Z are also the directors of C Pty Limited, the project manager responsible for overseeing and coordinating the development. As directors of D Pty Limited, X and Z, are also involved with the development of Lot 4. The B Trustee has also provided funds for development of Lot 4.

As such, the A Trustee cannot be looked at in isolation, as it is a part of the wider structure of the group doing the Development. Your acceptance that the Development is undertaken by the Group, rather than any one entity, is implied in the First Memorandum, with reference made to the Group’s interest in the land parcels that make up the Development, as well as the Group’s preference to achieve englobo sales.

You have stated that the A Trustee originally acquired the Property in order to develop it into industrial allotments, although documentation provided as part of the Private ruling application process makes it clear that the controlling minds always considered the possibility that the A Trustee may sell the Property on an englobo basis. In the First Memorandum, issued by the B Trust several years prior to the first purchase, it was stated that the Group’s preference is to “…achieve englobo land sales following Development Approval, but will adopt a flexible approach and could consider development of some land parcels.” Similar statements were made in the second and third memorandums. Parcels of the Property have been advertised for sale or lease. The option to purchase one lot has been exercised and the A Trustee took ownership. The property was agisted to an entity associated with the vendor. The facts of the case make it clear that the A Trustee always intended that the land would be held for the purpose of resale at a profit, whether that be development and sale of individual industrial lots or englobo sales of the industrial and/or mixed use development.

In Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (1978) 138 CLR 210, Jacobs J stated the following on whether land that has not been physically developed can be trading stock (at 235):

Once it is concluded that land may be trading stock, then I can see no reason to limit the application of the words to land which is in the condition in which it is intended that it should be sold. I am inclined to the view that land acquired or purchased for purposes of sale falls within the words of the definition whether or not the land is in the condition in which it is proposed that it should be sold. (see also Mason J at 228-229) .

The intention to resell the land for profit existed at the time the property was purchased and is ongoing. The precise means by which the profit on the sale of the land is to be realised may have changed over time, from sale of industrial lots, to sale of an englobo mixed-use development. However, it is considered that the land has been held for the purpose of sale from the time it was acquired.

Business activity has commenced

Once it is established that land is held for the purpose of sale, it is necessary to consider whether a business activity which involves dealing in land has commenced. TD 92/124 provides that a 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.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? sets out the Commissioners view on when an entity is carrying on a business. While TR 97/11 specifically considers whether an entity is carrying on a business of primary production, the Commissioner considers the indicators of business outlined below also apply to other areas:

26. From the judgments it is clear that the relevant indicators of whether a business of primary production is being carried on by a taxpayer are:

● does the activity have a significant commercial purpose or character?

● does the taxpayer have more than a mere intention to engage in business?

● is there an intention to make a profit or a genuine belief that a profit will be made? Will the activity be profitable?

● is there repetition and regularity in the activity? i.e., how often is the activity engaged in? How much time does the taxpayer spend on the activity?

● is the activity of the same kind and carried on in a similar way to that of the ordinary trade?

● is the activity organised in a businesslike manner?

● what is the size or scale of the activity?

● is the activity better described as a hobby, a form of recreation or a sporting activity?

These indicators of business will now be considered with reference to the A Trust:

● Although there is no formal documented business plan, The A Trust has a significant commercial purpose. The commercial purpose of the development is outlined in the three Information Memorandums issued by the B Trust;

● The A Trust has more than mere intention to engage in business. It has purchased one lot of the Property and continues to makes payments to maintain its rights over the other lots. It has also entered into another option agreement on a nearby property. The A Trust has entered into significant financing arrangements to fund the purchase. The A Trust is also actively engaged in the rezoning of the development, through the directors of the A Trustee and their project management company C Pty Limited;

● The intention and expectation to make a profit is outlined in the three Information Memorandums issued by the B Trust;

● Although there has been no repetition of sale activity, the scale of the activities undertaken in the course of the development is substantial. The A Trustee also intends to complete purchases on the other lots and has entered into a further option agreement to purchase additional adjacent land;

● The activity has been undertaken in a similar way to other property development businesses;

● Activities are organised in a business-like manner;

● The size and scale of the development is substantial; and

● The development clearly cannot be described as a hobby.

These indicators demonstrate that a business is being undertaken and along with the facts set out above, establish a definite and continuous cycle of operations designed to lead to the sale of the Property.

A wide survey of the group shows that the property development business is being undertaken by a number of entities in the group, including the A Trustee. An exact scrutiny of the A Trustee’s activities demonstrates that the A Trustee does not merely hold land, it is carrying on a property development business in conjunction with other members of the group.

It is considered that Lot 1 is held and Lots 2 and 3 of the Property will be held for the purpose of sale in the ordinary course of a business in the relevant income years. Lot 1 is trading stock and lots 2 and 3 will be trading stock, for the purposes of section 70-10 of the ITAA 1997.

Subsection 70-5 of the Income Tax Assessment Act 1997 (ITAA 1997) outlines the key features of tax accounting for trading stock. It provides that gross outgoings are generally deductible under section 8-1 of the ITAA 1997 and gross earnings are usually assessable as ordinary income under section 6-5 of the ITAA 1997.

Therefore, the gross proceeds from the sales of Lots 1, 2,and 3 of the Property will be ordinary income and taxed under section 6-5 of the ITAA 1997 in the income year in which the sale is completed. Any losses associated with the sale of the Property will be deductible under section 8-1 of the ITAA 1997.

Capital gains tax provisions

Although it is not necessary to consider the second question regarding the sale being a mere realisation of a capital asset, the effect of the capital gains tax provisions on trading stock will be considered for completeness.

Section 102-5 of the ITAA 1997 provides that your assessable income includes your net capital gain for the income year. Section 100-20 of the ITAA 1997 provides that you can only make a capital gain if a capital gains tax (CGT) event happens. The CGT events are outlined in Division 104 of the ITAA 1997. Most CGT events involve a CGT asset (section 100-25 of the ITAA 1997). CGT event A1 occurs when there is disposal of a CGT Asset.

Section 108-5 of the ITAA provides that a CGT asset is any kind of property, or a legal or equitable right that is not property (subsection 108-5(1)), and includes land and buildings (Note 1 to section 108-5).

Lots 1, 2 and 3 of the Property will be CGT assets.

Section 100-30 of the ITAA 1997 provides that a capital gain can be disregarded if there is an exception or exemption that allows it to be disregarded. Section 118-25 of the ITAA 1997 states that a capital gain made from a CGT asset is disregarded if at the time of the CGT event the CGT asset is trading stock.

Since Lots 1, 2 and 3 are considered to be trading stock of the A Trustee at the time of each sale, any capital gains made will be disregarded.

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