FC of T v KURTS DEVELOPMENT LIMITED

Members: Burchett J
Lindgren J

Emmett J

Tribunal:
Full Federal Court

Decision date: 28 August 1998

Emmett J

Kurts Development Limited (``the Taxpayer'') lodged objections against assessments issued by the Commissioner of Taxation (``the Commissioner'') under the Income Tax Assessment Act 1936 (Cth) (``the Act'') in relation to the years ended 30 June 1992 and 30 June 1993. The Commissioner's delegate allowed the objections in some respects but disallowed them in other respects. In so far as the objections were disallowed, the Taxpayer applied to the Administrative Appeals Tribunal (``the Tribunal'') for review of those objection decisions [ reported at Case 47/97,
97 ATC 485 ].

On 31 October 1997, the Tribunal decided that:

(a)... the objection decisions under review be set aside,
(b) the matters be remitted to the [ Commissioner] with directions to amend the assessments so as to give effect to the Tribunal's reasons for decision,
(c) [ the] proceedings have terminated in a manner favourable to the [ Taxpayer].

Pursuant to section 44 of the Administrative Appeals Tribunal Act 1975 (Cth), the Taxpayer lodged an appeal to this Court from the decision of the Tribunal. The Commissioner lodged two appeals, one in respect of each year of income. In accordance with section 44(3)(b)(ii) of the Administrative Appeals Tribunal Act , the Chief Justice determined that the appeals be heard by a Full Court and all three appeals have been heard together.

The questions before the Tribunal and before the Full Court concern the application of the trading stock provisions of the Act to the business activities of the Taxpayer. The relevant provisions of the Act are contained in sections 6(1), 28, 29, 31 and 51 and are as follows:

``Interpretation

6(1) In this Act, unless the contrary intention appears:

...

`trading stock' includes anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange, and also includes live stock;

...

Trading stock to be taken into account

28(1) Where a taxpayer carries on any business, the value, ascertained under this subdivision, of all trading stock on hand at the beginning of the year of income, and of all trading stock on hand at the end of that year shall be taken into account in ascertaining whether or not the taxpayer has a taxable income.

28(2) Where the value of all trading stock on hand at the end of the year of income exceeds the value of all trading stock on hand at the beginning of that year, the

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assessable income of the taxpayer shall include the amount of the excess.

28(3) Where the value of all trading stock on hand at the beginning of the year of income exceeds the value of all trading stock on hand at the end of that year, the amount of the excess shall be an allowable deduction.

Value at beginning of year of income

29(1) The value of live stock and of each article of other trading stock to be taken into account at the beginning of the year of income shall be its value as ascertained under this or the previous Act at the end of the year immediately preceding the year of income.

Value at end of year of income

31(1) Subject to this section, the value of each article of trading stock (not being live stock) to be taken into account at the end of the year of income shall be, at the option of the taxpayer, its cost price or market selling value or the price at which it can be replaced.

...

Losses and outgoings

51(1) All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.

51(2) Expenditure incurred or deemed to have been incurred in the purchase of stock used by the taxpayer as trading stock shall be deemed not to be an outgoing of capital or of a capital nature.''

The Taxpayer carries on the business of developing and subdividing undeveloped land (``broadacres'') in Queensland and New South Wales. It does so by buying broadacres, obtaining appropriate approvals, carrying out various construction works on the broadacres, subdividing the broadacres and selling the subdivided lots. It is common ground that the broadacres acquired by the Taxpayer for the purposes of development are trading stock of the Taxpayer within the meaning of the Act. The individual subdivided lots resulting from the development process are also trading stock of the Taxpayer. The Taxpayer has elected, pursuant to section 31 of the Act, that the value of its trading stock, for the purposes of section 28 of the Act, is to be its cost price.

While the State legislative provisions in Queensland and New South Wales are different in detail, they are substantially similar. Relevantly, as a practical matter, the Taxpayer is not permitted to complete the sale of, and cannot give title in respect of, individual subdivided lots until after the issue of separate titles in respect of the individual subdivided lots upon registration of a plan of subdivision. That is dependent upon the approval of the proposed subdivision by the local authority.

As a condition of obtaining approval of the local authority to the subdivision it usually is necessary for the Taxpayer to undertake, on certain parts (``the Infrastructure Land'') of the broadacres, work comprising the provision of services and facilities such as roads, parks, sewerage, drainage, electricity and telephone (``Infrastructure Works''). It is also a requirement of the granting of approval that the Infrastructure Land be dedicated to the Crown or a public authority. That dedication is effected upon and by the registration of a plan of subdivision.

There are generally six stages in the development process after the purchase of broadacres by the Taxpayer. They are as follows:

1. Rezoning.
An application for rezoning is lodged by the Taxpayer under the appropriate State legislation. The local authority reviews the application and any objections. If the application is approved, approval is generally given subject to the provision of certain services and to the subdivision's meeting certain criteria as to such matters as parkland, access and visual and noise standards. The approval is then submitted to the appropriate State department to ensure that the State's requirements have been met and to arrange gazettal of the rezoning.
2. Subdivision approval.
An application for a subdivision permit is made by the Taxpayer to the local authority. The application comprises a detailed plan

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showing the proposed road layout and how the conditions of the rezoning approval will be met. Once a subdivision permit is issued, the Taxpayer may begin to carry out engineering survey and design on the proposed development.
3. Engineering and design process.
The Taxpayer then begins a detailed engineering survey to determine the existing ground levels over the proposed road and lot locations. A full set of engineering drawings is lodged with the local authority and, if they are satisfactory, engineering approval is given by the local authority.
4. Construction process.
Following the award of tenders, officials of the local authority and the Taxpayer's consulting engineers discuss the proposed construction program and the local authority nominates the stages at which it wishes to inspect the construction works. Once the local authority accepts that the construction works have been carried out in accordance with its requirements, a period of several months ensues during which the Taxpayer must satisfy the local authority that the services and facilities which have been constructed are satisfactory. If the local authority is satisfied, it accepts responsibility for the services and facilities.
5. Plan sealing process.
The Taxpayer then lodges with the local authority a plan of survey giving details of the geometrical aspects of each lot, easement requirements and park and road dedications. Also lodged with the local authority are the documents required to transfer the parks and access restriction strips to the local authority and those required in relation to easements over lots. The Taxpayer also lodges documentation relating to the provision of other services such as telephone and electricity. The Taxpayer also makes any payments necessary for water, sewerage, roads, parks and ``headworks''. Once the local authority is satisfied that the development complies with the conditions stipulated in the rezoning approval and the subdivision permit, the plan of subdivision is sealed by the local authority. From that time, parks, open spaces, roads and services become the responsibility of the local authority.
6. Registration of titles.
Once the plan of subdivision has been sealed, the plan and other documentation are lodged with the Land Titles Office. Once the plan is registered, the subdivision is effected and separate titles are created in respect of the individual subdivided lots. At the same time, the ownership of the parks, roads, etc. vests in the local authority.

Thus, as the Taxpayer develops the broadacres, physical changes are made to it. Those physical changes include the construction of the services and facilities. As the development proceeds, the boundaries of the proposed individual lots become clearly marked, as do the boundaries of what is to become the Infrastructure Land. Nevertheless, prior to registration of the plan of subdivision, and despite those physical changes, the only disposable asset in the Taxpayer's hands remains the broadacres as originally acquired and the title to it remains unchanged.

However, at the moment of and by virtue of the registration of the plan of subdivision, the individual subdivided lots come into existence with separate title and the Taxpayer ceases to be the owner of the Infrastructure Land. It is only at that moment that the Infrastructure Land becomes an identifiable and segregated parcel of land subject to a separate title or titles, separate from the other part of the original broadacres. At no time is the Infrastructure Land, in the hands of the Taxpayer, an identifiable or separate parcel of land subject to separate title.

The specific questions in issue in the appeal concern the extent to which certain costs incurred by the Taxpayer in the development process should be treated as part of the cost price of the individual subdivided lots resulting from the development process. The costs in question fall into two categories which can be summarised as follows:

1. Costs incurred by the Taxpayer (``Infrastructure Costs'') in carrying out the Infrastructure Works.
2. Costs incurred by the Taxpayer (``External Costs'') as a condition of its obtaining approval from a local authority to a proposed subdivision, being payments made to local authorities for ``headworks'' and other works which are physically external to the land of the Taxpayer.

ATC 4882

The dispute is essentially one as to the timing of liability for tax in respect of the profit ultimately derived by the Taxpayer from the business of acquiring broadacres, developing them to the stage of individual subdivided lots and selling those lots. The Taxpayer's contentions may be summarised as follows:

(i) What is to become the Infrastructure Land and the services and facilities constructed thereon are as much part of the Taxpayer's trading stock as any other part of the broadacres from which the Infrastructure Land is to be ultimately excised.
(ii) When, during a year of income, parcels of Infrastructure Land vest in a local authority by reason of the registration of a plan of subdivision, the value of the Taxpayer's trading stock (determined by reference to its cost price) is reduced by the cost of the Infrastructure Land and services and facilities constructed thereon which vests in the local council. Thus, the value of the Taxpayer's trading stock at the end of the year of income is the cost of the individual subdivided lots on hand less the cost of that Infrastructure Land and the Infrastructure Costs relating to the Infrastructure Land. Those costs should be deducted from the cost of the broadacres held by the Taxpayer at the beginning of the year of income.
(iii) The Infrastructure Costs and the External Costs are allowable deductions under section 51(1) of the Act but never become part of the cost price of the Taxpayer's trading stock.

The Commissioner contends, however, that the effect of the trading stock provisions is as follows:

(a) Under section 51(1) of the Act, all costs in both categories incurred by the Taxpayer in a tax year, are allowable deductions in that tax year.
(b) Those costs are part of the cost price of the broadacres, and subsequently of the individual subdivided lots, so as to constitute part of the value of those lots for the purposes of section 28.
(c) Under section 28, the value of the land in whatever state it is at the end of any tax year, be it undeveloped or in subdivided lots, includes the expenditure incurred up to the end of that tax year.
(d) The consequence is that the increase in the value of the land held at the end of any year as trading stock is, in effect, set off against the allowable deduction under section 51(1).
(e) The gross proceeds of sale of the individual subdivided lots will form part of the Taxpayer's assessable income under section 25 in the year in which the relevant lots are sold.
(f) At the end of the tax year in which lots are sold, the value of trading stock will be reduced by the cost price of the lots sold and that reduction will be set off against the assessable income comprising the proceeds of sale of the lots.

The Tribunal considered that, even though the Infrastructure Land was developed during the period when the Taxpayer was carrying on a business, it could not at any time be said to be part of its trading stock. The Tribunal also concluded that the direct costs of providing services, whatever they may be, to each subdivided lot are part of the cost price of that subdivided lot. The cost price of the individual subdivided lots was also held to include such direct costs as the cost of the land comprising the subdivided lots, the cost of surveying the lots and the land required for the services and the cost of clearing, levelling, excavating and filling the land as required. On the other hand, costs related to such matters as surveying, engineering and soil testing must, according to the Tribunal's conclusions, each be analysed to determine whether they are related to the formation of individual subdivided lots or whether they should be attributed to the general costs of the development.

In addition, the Tribunal concluded that the cost price of the individual subdivided lots also includes the External Costs insofar as the External Costs are directly related to or directly connected with ``the provision of services to the development and so to the individual subdivided lots''. The reasoning of the Tribunal appears to be that services are provided for individual subdivided lots and not to the Infrastructure Land. In that sense they are being provided to ``the development'', which must, it appears, be understood as referring to the totality of the individual subdivided lots but not to the Infrastructure Land. The Tribunal did not consider that it was possible to make any general finding about the External Costs which

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the Tribunal considered must be examined to ascertain whether they are directly attributable to the services provided to the individual subdivided lots.

Thus, the effect of the Tribunal's decision is that, in relation to both Infrastructure Costs and External Costs, an apportionment exercise is required. That is to say, in so far as it is possible to characterise the Infrastructure Costs as being ``direct costs'' of the individual subdivided lots, those costs are to be treated as part of the cost price of the lot. Similarly, to the extent that External Costs can be shown to be ``directly related to'' or ``directly connected with'' the provision of services to individual subdivided lots, those costs will be treated as part of the cost price of those lots. Otherwise, the balance of both Infrastructure Costs and External Costs is to be treated only as costs of the development, and not part of the cost price of trading stock comprising the individual subdivided lots.

The expression ``article of trading stock'', as found in sections 29 and 31 of the Act, is hardly apt in relation to land. Nevertheless, once it is accepted, as it must be following FC of T v St Hubert's Island Pty Ltd 78 ATC 4104; (1977-1978) 138 CLR 210, that the trading stock provisions apply to the business of developing land for subdivision and sale, the language of sections 28 and 29 of the Act must be given effect in relation to land.

Broadacres, as originally acquired by the Taxpayer, will be an article or articles of trading stock. The partially developed broadacres, before individual subdivided lots are created by registration of a plan of subdivision, can be characterised as work in progress. Work in progress can also be regarded as trading stock for the purpose of section 28 (see St Hubert's Island Pty Ltd at ATC 4112; CLR 226). Accordingly, at the end of any tax year, before registration of the plan of subdivision creating the individual subdivided lots, Infrastructure Costs incurred prior to the end of that tax year will be part of the cost price of the Taxpayer's trading stock, being its work in progress consisting of the partly developed broadacres.

In one sense it is a statutory accident that Infrastructure Land is vested in the Crown or a local authority. At common law, public roads were owned by the adjoining owners of land ad medium filum . That is to say, the fee simple in a public road remained vested in the owners of the land adjoining the road. The dedication of a public road meant no more than the public were entitled to pass and repass upon it without committing trespass. Even under present legislative schemes relating to ownership of public roads by local authorities, the Infrastructure Land is dedicated to the public. It is not capable of being separately sold by the local authority unless, perhaps, the need for roadway access or other services no longer exists.

The development business of the Taxpayer involves a process of transmogrification or metamorphosis of broadacres. That is to say, the broadacres are converted into individual subdivided lots. The Taxpayer's contentions would lead to the conclusion that there are two categories of trading stock resulting from that process, being the individual subdivided lots and the Infrastructure Land. However, the reality is that the individual subdivided lots have a value which includes the road access and other services constructed on the Infrastructure Land.

It may be that an experienced developer will know what proportion of the broadacres will become Infrastructure Land. However, at the time of acquisition, that part of the broadacres which is to become Infrastructure Land is not identifiable. It cannot be said, in any economic or real sense, that that part of the broadacres which is subsequently identified as Infrastructure Land is ever a separate asset of the Taxpayer which can be treated, on its own, as an ``article of trading stock'' as contemplated by section 31 of the Act. It would therefore be artificial to treat the Infrastructure Land as a separate asset of the Taxpayer.

The area of the broadacres originally acquired by the Taxpayer remains unchanged on the surface of the earth. The Infrastructure Land always remains contiguous with various individual subdivided lots. The result of the development process, so far as the Taxpayer is concerned, is that it produces individual lots which have the benefit of access and services by means of the Infrastructure Land. The individual lots are the more valuable by reason of having the benefit of those services and facilities.

It is not possible for the Taxpayer to sell individual subdivided lots unless they have access to public roads to enable the owners to

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gain access to the lots themselves. That access is gained by means of the Infrastructure Land. There is no doubt that the expenditure of money by the Taxpayer on the Infrastructure Works adds to the value of the broadacres as a whole because it makes possible the separate disposition of the proposed individual subdivided lots. Without the roads, parks and other services and facilities, the individual subdivided lots could not be sold. In a real sense, the expenditure of the Infrastructure Costs is part of the cost of producing the individual subdivided lots.

The effect of the registration of the plan of subdivision is to convert the trading stock comprising the broadacres originally acquired by the Taxpayer into trading stock of a different category, namely, individual subdivided lots. Part of the cost of the creation of those lots is the construction of physical access and the dedication of the land on which that physical access and the other services and facilities are constructed. It is never the purpose of the Taxpayer to sell any part of the Infrastructure Land. It is never separately acquired because, as indicated above, at the time of acquisition, it would not normally be identifiable as land which will ultimately become Infrastructure Land.

The Taxpayer also relied on the definition of trading stock in the Act to support its contention that the Infrastructure Land should be separately characterised as trading stock. The definition refers to ``anything... acquired... for purposes of... exchange ''. However, it is not realistic to speak of the Infrastructure Land as having been acquired for the purpose of exchange. It is an unidentifiable part of the broadacres acquired for the purpose of development, subdivision and sale. It may be that the dedication of the Infrastructure Land is a condition precedent to obtaining the necessary consent of the local authority to the plan of subdivision. However, that is not in any sense an exchange. The ownership of the local authority is for public purposes and not otherwise. All that the Taxpayer receives in exchange from the local authority is consent to do something which would otherwise be prohibited by statute.

Once it is accepted that the Infrastructure Land is never at any stage a separate article of trading stock, the issue concerning Infrastructure Costs is resolved quite simply. The Taxpayer's business involves converting one form of trading stock into a different form of trading stock. One cost of so doing is the Infrastructure Costs. Another cost is the cost of the Infrastructure Land. Those costs are, therefore, properly to be characterised as part of the cost price of the resultant individual subdivided lots. Once the Taxpayer has exercised the option of valuing trading stock at cost price for the purposes of section 31(1) of the Act, those costs are part of the value of the individual subdivided lots for the purpose of section 28 of the Act.

That analysis also resolves the question concerning the External Costs. It does not matter that the External Costs are remote from the individual subdivided lots. Nor does it matter whether they are directly related to or directly connected with the individual subdivided lots. The question is whether the External Costs are properly to be characterised as part of the cost price of the individual subdivided lots. They are all expenses which had to be incurred in order to create the individual subdivided lots. But for that expenditure, the individual subdivided lots would not have been created. For that reason, the External Costs are also part of the cost price of the individual subdivided lots.

The individual subdivided lots which are created upon registration of the plan of subdivision are part of the trading stock of the Taxpayer. All of the costs incurred by the Taxpayer in creating those individual lots must be regarded as part of their cost price. There is no justification for drawing a distinction between direct costs of the lots on the one hand and general costs of the development on the other hand. Equally, there is no justification for treating the Infrastructure Costs as ``wasted'' or treating the Infrastructure Land as a ``waste product''. All of those costs are necessarily incurred in order to bring into existence the individual subdivided lots. They are all properly to be regarded as part of the cost price of the individual subdivided lots.

It follows that the Tribunal erred in law. The Taxpayer's appeal should be dismissed and the Commissioner's appeals should be upheld. The decision of the Tribunal to set aside the objection decisions under review and to remit the matters to the Commissioner should be set aside. In lieu thereof, the Taxpayer's application to the Tribunal for review should be

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dismissed. The Court has been informed that this proceeding forms part of the Commissioner's test case scheme and that the parties have agreed that there be no order as to the costs of the appeal in any event. Accordingly, there should be no order as to costs.

THE COURT ORDERS THAT:

1. The appeal be dismissed.

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