Edited version of your written advice

Authorisation Number: 1051278667152

Date of advice: 6 September 2017

Ruling

Subject: Capital gains tax – property – development – income vs capital

Question 1:

Will the profits from the sale of Property A and Property B be treated as ordinary income under section 6-5 Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 2:

Will the profits from the sale of Property A and Property B be assessed under the capital gains tax provisions contained in Parts 3-1 and 3-3 of the ITAA 1997?

Answer:

Yes.

This ruling applies for the following periods

Income year ending 30 June 201B

The scheme commences on

1 July 201A.

Relevant facts and circumstances

You attended numerous property portfolio seminars over a number of years.

After 20 September 1985, you purchased Property X which was your main residence until you purchased Property Y a number of years later, which was your main residence during your ownership period.

A number of years after you purchased Property Y you attended an initial meeting with an organisation (the Agents) in relation to the potential purchasing of other properties.

An employee (Person A) of the Agents sent you numerous emails about potential properties for your consideration.

A number of months later, you entered into a contract for the purchase of Property A.

Shortly after you entered into the contract to purchase Property A, Person A sent you an email about the property which included purchase details, a purchase costs summary and projected cash flow details in relation to both a renovated or unrenovated dwelling, and a building.

During the following month, a bank sent you a loan offer for a loan for residential investments for the amount of $XXX,XXX, for the term of X years, with Property A being listed as security for the loan.

During the following month Person A sent you an email about Property B in which they stated that the site could fit a building. Purchase details, a purchase costs summary and projected cash flow details for a renovated dwelling and a building in relation to Property B were provided.

In the following month, you entered into a contract for the purchase of Property B.

You engaged the services of a real estate agent (the Real Estate Agent) to manage Property A and Property B.

A number of months after Property A was purchased, a tenancy agreement was entered into for the lease of Property A.

Person A continued to send you emails about potential properties for your consideration after you purchased Property A and Property B.

A number of months after you entered into the contract to purchase Property B, a bank sent you a residential loan agreement offer for a residential investment loan for the amount of $XXX,XXX, for the term of X years, with Property B being listed as security for the loan.

During the same month, an insurance company sent you an email in relation to the landlord insurance for Property B effective for 12 months.

In the following month, a building was constructed at Property A.

A short time later the Real Estate Agent sent you a letter which included a copy of the advertisement for the rental of Property B for $XXX per week with a residential tenancy agreement being entered into around that time.

A number of months later, Person B from Company A emailed you an advertisement which outlined dual living in a major city where a house would be a house on the outside and be two rentals on the inside.

The following day you forwarded an email you had received from Person B to Person A in which you queried whether the dual living would be something that could be considered in relation to Property B.

During the same month, a development application was lodged with the council in relation to the construction of a detached building at Property A with approval being granted by the council a number of months later.

A number of months later the Real Estate Agent sent an email advising that the building at Property A had been rented.

During the following month the Final Occupation Certificate for the building located at Property A was issued.

Later on during the same month plans for the construction of a dual occupancy dwelling at Property B were prepared.

You are the co-founder of a number of entities and a number of months after the plans for the dual occupancy dwelling had been drawn up you commenced a new business project (the Project) which you funded.

You engaged the services of Company XYZ to undertake activities in relation to the Project which was to be completed by the end of 201A, to be put on the market during the following months. The initial cost agreement was estimated at $XXX,XXX, with variations and additional work paid separately.

In early 201A, you sold Property Y to fund the Project.

During the following month, your insurance company sent an email in relation to the renewal of your landlord insurance policy for Property B, which would expire in 201B.

You were engaged in a management position with a Company (Company 5) which provided management and labour to numerous entities (the Businesses) in which you an interest with some other partners.

A meeting was held to discuss the cessation of your involvement in the Businesses by calling up a loan you owed for the shares in the Businesses, and the potential cessation of your income from the Businesses.

During the same month you entered into a contract to sell Property A.

Person X sent an email to you outlining the points that had been mutually agreed upon during the discussions. These points have been submitted.

You did not repay the loan by the specified date and your income from the Businesses ceased a number of months after Person X had sent the email.

During the month your income from the Businesses had ceased you entered into a contract for the sale of Property B with settlement occurring after a number of months.

A number of months after your income from the Businesses had ceased, you entered into a contract for the sale of Property A, with settlement after a short period.

You have calculated that the net capital gain amounts arising in relation to the sale of the properties is as follows:

● $XX,XXX on the disposal of Property A; and

● $XXX,XXX on the disposal of Property B.

You did not repay the loan you obtained from Person X by the due date, and forfeited your enlistments in the Businesses.

At this point:

● you have paid over $XXX,XXX to Company XYZ;

● the Project has not been finalised due to numerous errors;

● you are currently in a legal dispute with Company XYZ as they did not deliver the product in accordance with the agreement, and the product is not finalised; and

● you are seeking financial compensation for some of the fees paid so that you can engage the services of another company to finalise the Project.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-15

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1936 Subsection 25(1)

Reasons for decision

Taxation treatment of property sales

There are three ways profits from a land sub-division can be treated for taxation purposes:

(1) As ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock; or

(2) As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of an isolated commercial transaction entered into by a non-business taxpayer or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose; or

(3) As statutory income under the capital gains tax (CGT) legislation contained in Parts 3-1 and 3-3 of the ITAA 1997 on the basis that a realisation of a capital asset has occurred.

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

Carrying on a business of property development

The Commissioners view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) Although TR 97/11 deals with the issues of determining whether a taxpayer is carrying on a business of primary production, the same principles can be applied to the question of whether a taxpayer is in the business of property development.

Paragraph 13 of TR 97/11, uses the following indicators to determine whether a taxpayer is carrying on a business:

● whether the activity has a significant commercial purpose or character;

● whether there is repetition and regularity of the activity;

● whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

● whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at 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 a 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 flavor.

Isolated business transactions

Profits from isolated transactions will be assessable as ordinary income where the intention or purpose in entering into the transaction was to make a profit or gain and the transaction was entered into and the profit was made in the course of carrying out a business operation or commercial transaction

Taxation Ruling TR 92/3 (TR 92/3) sets out the Commissioner’s view of the general principles and factors that have been considered in determining whether an isolated transaction is of a revenue nature.

Paragraph 13 of TR 92/3 lists the following factors which are relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction include:

● 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 that property; and

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

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.

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.

The intention of the taxpayers was a vital consideration for the court in McCurry v. FCT (1998) 39 ATR 121 (McCurry) in determining whether the taxpayer’s activities constituted a profit-making undertaking or scheme which was a business or commercial dealing.

Broadly, McCurry involved two brothers acquiring land in rural South Australia and constructing three townhouses on the land financed from borrowings and their own funds. Although the taxpayers argued that the reasons for their sale was due to financial difficulties, a further affidavit supplied contradicted this by their admittance that one of their purposes was acquisition and sale for a profit and they considered it to be a good time to sell.

The court in McCurry concluded that the taxpayers had entered into a profit-making undertaking or scheme and the profits were assessable under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936), the predecessor provision of section 6-5 of the ITAA 1997. Davies J remarking in the decision (at ATC 4489):

If a property is acquired in the course of a business or commercial dealing with a view to obtaining a profit from its development and sale, that venture is not regarded as an investment and the profit derived therefrom is income for the purpose of sec 25(1). Here, the taxpayers entered into a commercial dealing.

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.

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 happens if you dispose of your ownership interest a CGT asset. The time of the event is either when you enter into a contract for the disposal, or when the change of ownership occurs if there is no contract.

You will make a capital gain if the capital proceeds from the disposal of a CGT asset are more than the cost base of the CGT asset. You will make a capital loss of those capital proceeds are less than the reduced cost base of the CGT asset.

Application to your situation

You purchased Property A and Property B after 20 September 1985 and used them to earn rental income. The loans you obtained to purchase the properties were residential investment loans for X year terms.

You constructed a building at Property A in the year after it was purchased, which you rented out. You had plans drawn up for the construction of a dual occupancy dwelling at Property B.

A number of months after you had purchased the properties you commenced the Project, which you funded. At this point you have spent more than $XXX,XXX on the Project.

In the email sent by Person X after you had commenced the Project, you were advised that loan of $XXX,XXX you owed to them was being called up and that if you did not repay it by a specified date your income in relation to the Businesses would cease as of the specified date. You did not repay the loan by the specified date and your income from the Businesses ceased.

Following the loss of your income from the Businesses you decided to sell Property A and Property B and continue with the Project.

The following statements were made in the ruling:

● you attended numerous seminars over many years and determined that it would make more sense financially for you to build a solid portfolio and not sell properties so that you would gain greater rental;

● your intention had been to purchase 10-15 properties to generate rental income, and that after around 10 years you would phase out of your role with Company 5;

● you decided to build your portfolio of investment properties after you had purchased Property Y;

● you were a shareholder and manager in the Businesses which provided you with a steady income to purchase the rental properties, however your working relationship with your business partners ended and your income ceased. At that time Property A and Property B were negatively geared;

● the Project proved to be financially demanding and you couldn’t keep up with the mortgage payments due to your financial position;

● due to the financial demands of the Project, and due to your financial situation, you made the decision to put Property A and Property B on the market;

● it was not your intention to sell any of your properties and they were not purchased with the intention to renovate or “flip over” the properties, but had been purchased with the intention of building an extra dwelling on each property under the same title to generate double rental income from them; and

● you are the director of Company ABC and were involved in the development of properties being undertaken by your family trusts (the Trusts). The Trusts were to undertake projects where they would purchase properties for the purpose of constructing units on them and then selling the units. You engaged a development company to build the units on one property, with construction nearly completed. The mortgage for that property was structured as a development mortgage. Due to your financial difficulties, you were forced to sell another property without being able to start the development.

After reviewing the information and documentation provided, it is the Commissioner’s view that your activities are not those of an entity carrying on a business of developing and selling properties because the activities undertaken do not display the salient indicator of a business, which are transactions entered into on a continuous and repetitive basis.

Your facts are not like the McCurry case as outlined above, and the information and documentation provided supports that your intention when the properties were purchased was to use them as long term investment properties. The properties were intended to produce positive income given that you had planned to earn two rental incomes from each of the properties.

It is viewed that as a result of your loss of income from the Businesses and the financial demands of the Project, the feasibility of your intention to keep Property A and Property B for investment purposes changed to selling them due to the change in your financial situation. Your actions in selling the properties are consistent with someone getting out of an investment because their circumstances have changed and they are seeking to prevent, or reduce, any loss made in relation to the investment. In this case, by selling Property A and Property B as quickly as you could to reduce any adverse consequences that may arise due to the change in your financial circumstances.

Accordingly, we view that based on the facts of your situation you had no profit making intention on acquisition of the properties from their sale, and that the activities you have taken in relation to the sale of the properties were undertaken to avoid any losses being made in relation to the properties. While you have made a profit on the sale of Property A and Property B, it cannot be said that the reason for the sale of the properties was to make a profit or gain based on the facts of your situation.

In conclusion, after weighing up the indicators as outlined in TR 97/11 and the factors outlined in TR 92/3 and applying them to the facts of your situation we have determined that the profits arising from the sale of Property A and Property B will not be on revenue account in relation to either the carrying on of a business or a profit making undertaking.

Therefore, any profit arising from the sale of Property A and Property B will be accounted for under the capital gains tax provisions in Part 3-1 and 3-3 of the ITAA 1997.

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