Edited version of private ruling

Authorisation Number: 1011674443987

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Ruling

Subject: Sale of duplex blocks - capital gain or ordinary income

Question 1

Is the profit made from the sale of the blocks ordinary income?

Answer

No

Question 2

If it is not ordinary income, is it a capital gain?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The taxpayer originally bought raw land a considerable time ago.

The land was purchased for the expansion of a business operating on a neighbouring property.

The land was developed some years later to expand the business and in addition a number of duplex blocks were created as a condition of the local council development approval.

The taxpayer planned to construct rental accommodation. The view was for the taxpayer to retain ownership of the land and operate development as a part of its business.

The development of the duplex blocks was delayed because of the global financial crisis and its impact on financing the development.

In the recent income year the decision was made to reduce the taxpayer's debt exposure by selling the duplex blocks.

An offer was made by a development company to purchase the blocks for $XX0,000. This offer is still under consideration pending advice regarding the tax situation.

The approximate cost of acquisition and improvement per duplex block is $X0,000.

The only improvements made to the land were: street curb and channel, stormwater pipe work, electrical power boxes, fencing and site survey works.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-10

Reasons for decision

Question 1

Summary

The profit or gain from the sale of the duplex blocks will not be ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

There are three ways profits from property sales can be treated for taxation purposes:

(1) As ordinary income under section 6-5 of the ITAA 1997 as a result of carrying on a business of property development and involving the sale of property as trading stock. Ordinary income is defined as income according to ordinary concepts.

(2) As ordinary income under section 6-5 of the ITAA 1997 as a result of an isolated business transaction which, although outside the ordinary course of business of a taxpayer, is entered into for the commercial exploitation of an asset acquired for a profit making purpose, that is, the profit is derived in the course of carrying out a business operation or commercial transaction.

(3) As statutory income under the capital gains tax (CGT) provisions in Pt 3-1 and 3-3 of the ITAA 1997, on the basis that the profit represents the realisation of a capital asset.

Case law on profits from sale of assets

In London Australia Investment Co Ltd v. FC of T (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 ("the London Australia Investment case"), the High Court held that profits on sale of an asset derived from the carrying on of a business constituted income if the buying and selling of the assets was carried out as part of that business.

The principle that profits made in the ordinary course of carrying on a business constitute income and is not of a capital nature was confirmed in FC of T v. The Myer Emporium Ltd (1987) 87 ATC 4363; 163 CLR 199; 18 ATR 693 ("Myer case"). The High Court also held that a profit arising from an isolated transaction which, although not made within the ordinary course of the taxpayer's business, was entered into with the purpose of making a profit and in the course of the taxpayer's business might well constitute income.

The Full High Court stated (at pp 4366-4367):

' … Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. … Nor does the fact that a profit or gain is made as a result of an isolated or a 'one-off' transaction preclude it from being properly characterized as income (FC of T v Whitfords Beach Pty Ltd 82 ATC 4031 at pp 4036-4037, 4042...). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.'

The general principles established in case law on these two issues are examined in Taxation Rulings TR 97/11 and TR 92/3.

Profits from carrying on a business

TR97/11 lists the relevant indicators in determining whether a taxpayer carries on a business for tax purposes.

It points out that no one indicator is decisive and they must be considered in combination and as a whole. The conclusion is drawn on the basis of the evidence and facts as to whether these indicators provide the operations with a commercial flavour.

In this case, the taxpayer is not carrying on a business of property development. It is carrying on a business of managing and renting home sites.. Therefore it could not be said that any profit made in the sale of the duplex blocks has been gained in the ordinary course carrying on its business.

Profits from isolated transactions

The Myer case is authority for the principle that profits arising from an isolated business or commercial transaction constitute ordinary income if the taxpayer's purpose or intention in entering into the transaction was to make a profit, notwithstanding that the transaction was not part of its daily business activities.

TR 92/3 sets out the Commissioner's view of the principles that have been considered in determining whether an isolated transaction is of a revenue nature. It states that a profit from an isolated transaction is generally income when both of the following elements are present:

· the intention or purpose of the taxpayer 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 on a business or in carrying out a business operation or commercial transaction.

The relevant intention or purpose of the taxpayer in 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. It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose.

In relation to purpose where there has been a sale of property paragraph 41 of TR 92/3 notes that:

If a transaction or operation involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However … that is not always the case.

Purpose is further discussed in paragraphs 51 to 58 of TR 92/3 in answer to the question of whether there must be a purpose of profit making by the very means by which the profit was in fact made. The following question is posed in paragraph 51:

...What if, however, at the time a taxpayer enters a transaction with a profit making purpose it contemplates a number of possible methods of making that profit or it did not have in mind any particular means of making the profit?

It continues in paragraph 52:

This issue was considered by the Full Federal Court in Westfield Limited v FC of T. At 91 ATC 4243; 21 ATR 1408, Hill J (with whom Lockhart and Gummow JJ agreed) said:

'…where a transaction falls outside the ordinary scope of the business, so as not to be a part of that business, there must exist, in my opinion, a purpose of profit making by the very means by which the profit was in fact made. So much is implicit in the decision of the High Court in Myer.'

As noted in paragraph 54, Hill J went on to say:

…it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit making scheme, where, in the case of a scheme involving the acquisition and resale of land, there was, at the time of the acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold.

Paragraph 56 concludes by stating that it is the ATO view that a profit made in either of the following situations is income:

· a taxpayer acquires property with a purpose of making a profit by which ever means prove most suitable and a profit is later obtained by any means which implements the initial profit-making purpose…or

· a taxpayer acquires property contemplating a number of different methods of making a profit and uses one of those methods in making a profit.

For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character. Some matters which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following:

1 the nature of the entity undertaking the operation or transaction;

2 the nature and scale of other activities undertaken by the taxpayer;

3 the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

4 the nature, scale and complexity of the operation or transaction;

5 the manner in which the operation or transaction was entered into or carried out;

6 the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

7 if the transaction involves the acquisition and disposal of property, the nature of that property; and

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

The facts do not lend weight to the conclusion that the taxpayer initially purchased the land either

· in order to make a profit by whatever means were most suitable or

· contemplating a number of ways to make a profit with the land.

The taxpayer purchased the land on which the duplex blocks have been developed more than 20 years ago with the purpose of expanding its business. In purchasing the land the purpose would have been to make a profit from that business.

Until recently, there was an intention to use the land to provide rental accommodation. This too would have been the intended source of any profit.

The taxpayer's purpose in selling the duplex blocks may result in a gain or profit but the transaction is not business or commercial in character.

The requirement to create the duplex blocks was part of the council's development approval. The taxpayer did not seek to create those blocks in order to sell them for a profit, but to comply with the council's requirements.

The taxpayer's main purpose in now selling the duplex blocks is to reduce its debt exposure. The delay in building the accommodation on the duplex blocks was also related to financing difficulties.

In conclusion the intention or purpose of the taxpayer in entering into the sale is not to make a profit in the course of carrying on the business or in carrying out a business operation or commercial transaction.

Since this is the case, any profit or gain made in the sale of the blocks will not be ordinary income under section 6-5 of the ITAA 1997.

Question 2

Summary

Any gain made as a result of the sale of the duplex blocks is a capital gain.

Detailed reasoning

Net capital gains are included as part of assessable income by section 102-5 of the ITAA 1997. Under subsection 102-20 of the ITAA 1997 you can only make a capital gain or loss if a capital gains tax (CGT) event occurs. There are many different types of CGT events which cover a variety of circumstances in which CGT can apply. The event that is applicable to the sale of the duplex blocks is event A1 - disposal of a CGT asset.

The conditions under which a CGT event A1 occurs are listed in section 104-10 of the ITAA 1997:

Disposal of a CGT asset: CGT event A1  

104-10(1) CGT event A1 happens if you *dispose of a *CGT asset.

104-10(2) You dispose of a *CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

104-10(3) The time of the event is:

(a) when you enter into the contract for the *disposal; or

(b) if there is no contract - when the change of ownership occurs.

Example:

In June 1999 you enter into a contract to sell land. The contract is settled in October 1999. You make a capital gain of $50,000.

The gain is made in the 1998-99 income year (the year you entered into the contract) and not the 1999-2000 income year (the year that settlement takes place).

104-10(4) You make a capital gain if the *capital proceeds from the disposal are more than the asset's *cost base. You make a capital loss if those capital proceeds are less than the asset's *reduced cost base.

Exceptions

104-10(5)  A *capital gain or *capital loss you make is disregarded if:

(a) you *acquired the asset before 20 September 1985; or

(b) for a lease that you granted:

(i) it was granted before that day; or

(ii) if it has been renewed or extended - the start of the last renewal or extension occurred before that day.

CGT asset is defined under subsection 108-5 of the ITAA 1997 as:

· any kind of property; or

· a legal or equitable right that is not property.

The duplex blocks are a CGT asset, the taxpayer intends to dispose of the assets by selling them.

If the cost base of the duplex blocks is $X0,000 approximately, and the sale price is $XX0,000 per block there will be a capital gain.