Edited version of private advice

Authorisation Number: 1051524636905

Date of advice: 2 July 2019

Ruling

Subject: Blackhole expenditures and forfeited deposit

Question 1

Is the forfeited deposit deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

No

Question 2

Are the conveyancing fees deductible under section 40-880 of the ITAA 1997?

Answer 2

No

Question 3

Are the legal expenses incurred to validly rescind the contract and to litigate claims against the vendors deductible under section 40-880 of the ITAA 1997?

Answer 3

No

Question 4

Are the expenditures you incurred deductible under section 40-880 of the ITAA 1997?

Answer 4

Yes

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

You acquired land. The contract price was to be settled a year after the contract date. You paid a deposit amount and conveyancing fees.

You intended to purchase the property to develop and sell retail spaces and residential units.

After date of possession, you engaged experts to embark on the property development activities and you incurred relevant fees and expenses.

The project's initial activities commenced. However, the Council refused to issue development consent for the land.

You did not complete the transaction on the agreed settlement date. The vendors demanded you to complete the transaction; but, you contend that you rescinded the contract.

The vendors terminated the contract and you forfeited the deposit.

You initiated legal proceedings against the vendors, the real estate agent and its director/shareholder for a number of heads of claim.

You sought a declaration from the Court that you validly rescinded the contract between you and the defendants. You also sought an order for the defendants to return to you the forfeited deposit amount and for the defendants to pay damages, costs and interests.

You incurred legal expenses.

The defendant offered you a settlement amount in relation to the deposit. You accepted the offer.

You filed a notice of discontinuance with the Court. The parties to the proceedings agreed to vacate all prior costs orders and that no order as to costs, with the intention that each party pay its and their own costs of the proceeding.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 subsection 40-880(5)(f)

Income Tax Assessment Act 1997 subsection 102-25(1)

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 subsection 116-30(1)

Income Tax Assessment Act 1997 subsection 116-30(3A)

Reasons for decision

Deduction under section 40-880 of the Income Tax Assessment Act 1997

Section 40-880 of the ITAA 1997 provides a deduction for business capital expenditure. It is a provision of last resort such that a deduction is not available under section 40-880 of the ITAA 1997 if the expenditure is otherwise available under some other provision (paragraph 40-880(1)(a) of the ITAA 1997).

The object of section 40-880(1) of the ITAA 1997 is to make certain business capital expenditure deductible over 5 years if:

a.     the expenditure is not otherwise taken into account; and

2. the deduction is not denied by some other provision; and
3. the business is, was or is proposed to be carried on for a taxable purpose.

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

1. in relation to your business; or
2. in relation to a business that used to be carried on; or
3. in relation to a business proposed to be carried on; or
4. to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues is the Commissioner's view of identifying the key issues which need to be resolved to establish entitlement to a deduction under the provision.

There are various pre-business expenses that would be incurred 'in relation to' a proposed business. These include, but are not limited to, expenditures to investigate the viability of the business (eg, feasibility studies or market research), establishment costs (such as the costs of establishing the business structure), or expenses that are a necessary precedent to the business being carried on (costs of market testing or putting in a tender).

Once entitlement is initially established and the limitations are considered, further restrictions may be placed on the amount of expenditure which is deductible.

Expenditures that could be taken into account in working out the amount of a capital gain or capital loss from a CGT event cannot be deducted as business related costs (section 40-880(5)(f)).

CGT asset and CGT event

Section 108-5 of the ITAA 1997 included the right to enforce a contractual obligation as an example of a CGT asset. Under section 104-25 of the ITAA 1997, CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

1. being redeemed or cancelled; or
2. being released, discharged or satisfied; or
3. expiring; or
4. being abandoned, surrendered or forfeited; or
5. if the asset is an option - being exercised; or
6. if the asset is a convertible interest - being converted.

Section 110-25 of the ITAA 1997 provides the general rules regarding cost base. The cost base consists of five elements:

·        Acquisition costs

·        Incidental costs

·        Non-capital ownership costs which are not deductible elsewhere

·        Amounts which increase or preserve the value of the asset

·        Amounts incurred in establishing, preserving or defending your title to the asset, or right over the asset

Taxation Ruling TR 1999/19 Income tax capital gains: treatment of forfeited deposits explains the CGT consequences of receipt by a vendor of a forfeited deposit, forfeited instalments of the purchase price and damages; and the payment by a purchaser of a deposit that is forfeited. Paragraphs 21 to 24 state:

21. If a purchaser forfeits a deposit, either CGT event C1 in section 104-20 (about a loss or destruction of a CGT asset) or CGT event C2 in section 104-25 happens, whichever CGT event is the more specific to the circumstances of the case: subsection 102-25(1).

22. No consideration is usually received by a purchaser on the termination of their contractual rights. If no capital proceeds are received from a CGT event, generally the purchaser is taken to have received the market value of the CGT asset that is the subject of the event (subsections 116-30(1) and 116-30(3A)).

23. The market value of the right to a transfer of the real estate is the value of the real estate less the amount still to be paid. If the market value of the real estate at the time of termination of the contract has dropped below the balance payable on completion of the contract, the market value of the contractual rights is nil and a bona fide purchaser is entitled to a capital loss, being the amount of the deposit forfeited plus incidental costs.

24. If CGT event C1 is the most specific CGT event, the market value substitution rule does not apply and a bona fide purchaser is entitled to a capital loss of the amount of the deposit forfeited plus incidental costs, regardless of the market value of the contractual rights or the underlying real estate. If CGT event C2 is the most specific CGT event, the market value substitution rule applies and a bone fide purchaser might not make a capital loss.

If the circumstances are of a voluntary nature, for example, if a purchaser defaults simply by changing their mind, deciding to invest elsewhere or the like, CGT event C2 is the more specific CGT event. If the circumstances are of a genuinely involuntary nature, for example, if a purchaser defaults because their finance fails, or because of extenuating personal circumstances, e.g., death of spouse, severe illness, natural disaster, CGT event C1 is the more specific CGT event (paragraphs 122-123 TR 199/19).

Application to your circumstances

In your statement of claim, you alleged that the vendors made false and misleading representations that the property can be developed to a certain number of retail spaces and residential units. You intended to acquire the property and acted on these representations. The Council denied your application. Notwithstanding your position that you would not have entered into the contract have you been made aware of the correct status of the property and that you contend that you have validly rescinded the contract; you forfeited the deposit and discontinued the proceedings. It is considered that the nature of your default is voluntary and falls under a CGT event C2.

Furthermore, CGT event C2 in subsection 104-25(1) happens when the taxpayer agrees to a release, discharge, satisfaction or surrender of their right to seek compensation. This is at the final point of settlement of the claim, whether in the course of Court proceedings, or in an out of Court arrangement. The time of the event determined by subsection 104-25(2) is the time of entering into the relevant contract or when the asset ends. This may be the entering into the contract, the settlement agreement, or when the Court makes a determination (paragraph 97 TR 1999/19). In your case CGT event C2 happened when you agreed to surrender your right to seek compensation by discontinuing the proceedings.

The provisions on the deductibility of business related costs exclude expenditures that can be taken into account in working out the amount of a capital gain or capital loss from a CGT event. The forfeited deposit amount is considered to form part of the acquisition costs. The conveyancing fees are incidental costs. And the legal fees and charges connected with the proceedings and incurred during the course of proceedings may be included in the cost base of the asset in terms of subsection 110-25(3) and section 110-35 of ITAA 1997. Therefore the said costs that you incurred are not deductible under section 40-880.

The various pre-business expenses incurred 'in relation to' your proposed business in property development are considered to be deductible under section 40-880 of the ITAA 1997. You have provided details of the expenses that would be deductible under this section.

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