Edited version of private ruling

Authorisation Number: 1011671047654

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Ruling

Subject: Strata titled timber plantation income and expenses

1. Do the proceeds from the sale of timber form part of your assessable income?

Yes.

2. Is the interest on the loan used to purchase the land and fees paid to the management company allowable as a deduction?

Yes.

3. Is the portion of the loan that relates to the plantation limited and calculated according to the land size of the area?

No.

4. Should the property be sold, would the cost base of the plantation be calculated according to the land size for capital gains tax (CGT) purposes?

No.

5. Is interest deductible in years prior to any income being derived?

Yes.

This ruling applies for the following periods:

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2007

Relevant facts

You have a property which is your principal residence.

You began the process of purchasing another block of land under a strata title plan of which one hectare is zoned for residential use and the balance is zoned for rural use. The strata plan comprises a number of lots of a similar size.

You intend to build a new residence on the section zoned for residential use at some indeterminate time in the future. The section of the land zoned for rural use is described as communal property and was planted with trees at the time of purchase. Each of the blocks is divided in the same fashion between residential and rural use with the result that a number of hectares of communal property is planted with trees. Each owner is entitled to a pro-rated share of any proceeds from the sale of the timber.

Timber was harvested and you received your share of the proceeds. With the trees being felled at the stump, they will continue to grow and there is an expectation of future proceeds being received from this source. You have advised that there is a turnaround period of about 10 years between each felling of the trees. It is accepted that the trees harvested would have been planted no later than 1999.

You have incurred expenses consisting of administration fees and plantation levies paid to the manager on a quarterly basis and interest incurred on the funds borrowed to purchase the land. The quarterly administration and plantation levies are calculated on the basis of each lot owner contributing a pro-rated share of the charges.

Reasons for decision

Question 1 - Do the proceeds from the sale of timber form part of your assessable income?

Your assessable income includes income according to ordinary concepts, which is called ordinary income. Income from carrying on a business is ordinary income and is therefore assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

A taxpayer who is engaged in forest operations is a primary producer for income tax purposes if those activities constitute the carrying on of a business. The definition of a primary production business is found at section 995-1(1) of the ITAA 1997 and provides, insofar as it is relevant here, that you are carrying on a primary production business if you carry on a business of planting or tending trees in a plantation or a forest that are intended to be felled, or felling trees in a plantation or forest.

The Full Federal Court in Hance & Anor v. FC of T 2008 ATC 20-085; (2008) 74 ATR 644 (Hance) decided that the taxpayers were carrying on business as a result of their participation in a managed investment scheme involving the growth and sale of almonds. Under the scheme each participant would own the almonds grown on their lot but generally the almonds would be pooled for sales and the proceeds shared on a pro rata basis based on the number of lots owned. The growers would, in the main, delegate the day to day management of the scheme to a manager.

The Commissioner had advanced the argument that the taxpayers were passive investors as borne out by the extent to which they would delegate their ability to control the relevant operations and had no proprietary right to the proceeds of almonds produced on their lots. These factors were said to result in the conclusion, among others, that the taxpayers would not be carrying on a business.

The Court rejected the argument that the taxpayers would give up any right of ownership of almonds produced on their lots and held that up until the sale of the almonds they would retain ownership, which would extend to them being able to withdraw their almonds from any pooling arrangement up until the point of sale. The Court also rejected the argument that the extent of delegation would have any material effect. In particular, the Court said that the argument of the Commissioner here 'focuses too much upon what the applicants will not be doing and pays too little attention to what they will be doing' (at 77).

Based on these findings, the Court determined that the relevant outgoings would be incurred in the carrying on of a business.

In your case, the circumstances are very similar to those in Hance whereby you have entered into a pooling arrangement for the sale of timber through a manager and appear to retain ownership of the timber until the point of sale. As demonstrated by the Court decision, the fact that you have delegated the day to day management of the scheme is not an impediment in determining whether you are engaged in business.

You are considered to be carrying on a business and the income generated from the sale of timber is therefore assessable income in terms of section 6-5 of the ITAA 1997.

Question 2 - Is the interest on the loan used to purchase the land and fees paid to the management company allowable as a deduction?

Losses and outgoings incurred in carrying on a business or in deriving assessable income are deductible under section 8-1 of the ITAA 1997 so long as it is not expenditure of a capital, private or domestic nature and is not incurred in deriving exempt income.

For the reasons stated above, you are considered to be carrying on a business of forest operations and interest and management fees incurred in connection with this activity will be deductible because the outgoings are necessarily incurred in carrying on a business.

Question 3 - Is the portion of the loan that relates to the plantation limited and calculated according to the land size of the area?

Loan interest incurred in carrying on a business is deductible under section 8-1 of the ITAA 1997.

Your business is conducted on the section of land zoned for rural use, while the section zoned for residential use is unconnected to the business activity. It is therefore appropriate to apportion the loan interest on the basis of the respective value of each section.

The Commissioner's views on this matter are expressed in Taxation Determination TD 93/13 which provides that the deductibility is determined by the use of the borrowed money. If the money is used to buy income producing property, the interest expense is an allowable deduction.

If the money borrowed is used only partly to produce assessable income, only that part of the interest which relates to the production of assessable income is an allowable deduction.

Since the loan was obtained in order to acquire an income producing asset (the rural section) and a non income producing asset (the residential section) it is necessary to apportion the interest deductible in the most appropriate manner and this should be done on the basis of the respective value of each section at the time of purchase.

An apportionment based on the respective land sizes is not appropriate because it assumes that the entire lot is of equal value. This may not be the case.

Question 4 - Should the property be sold, would the cost base of the plantation be calculated according to the land size for CGT purposes?

A capital gain or loss is disregarded in respect of a taxpayer's main residence. However, the total area of the land subject to the exemption must not exceed two hectares.

Taxation Determination TD 1999/67 provides that a capital gain or capital loss you make from the sale of land is only disregarded under the main residence exemption if it is used primarily for private or domestic purposes in association with your dwelling.

If your selected area of land can be separately valued, you calculate your capital gain or capital loss on the remainder of your land by apportioning the capital proceeds and the cost base or reduced cost base (if applicable) on the basis of the valuation. This is relevant if the value of the remainder of the land is of a greater or lesser value than your selected area of land.

In your case, the Commissioner's view is that each section should be separately valued as you are able to differentiate between the sections based on their respective zoning uses and were able to do so at the time of purchase.

Question 5 - Is interest deductible in years prior to any income being derived?

The deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put. Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean that the interest outgoings are therefore on capital account (Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele)).

It follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in the gaining or producing the assessable income in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activity and is not a prelude to those activities

· the interest is not private or domestic

· the period of interest outgoing prior to the derivation of relevant assessable income is not so long that the necessary connection between outgoings and assessable income is lost

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In your case, the trees were planted a number of years prior to you purchasing the property and as such it is accepted that the forest operations had commenced. It is therefore considered as you are carrying on a business of forestry operations, interest expenses will be deductible from the time that you purchased the land.

The interest deduction will need to be apportioned between the business and private use of the property as the section zoned for residential use is not part of the forest operation. The apportionment should be made on the basis of a valuation of each section of land as stated above.

Further issues for you to consider

The non commercial loss provisions may apply to any losses incurred in relation to this venture unless the Commissioner applies his discretion not to defer the loss. If the discretion is not applied, the losses incurred are prevented from being offset against other assessable income derived in that year of income and may be carried forward to a future year when there is a profit from the non commercial activity.