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Ruling

Subject: Property subdivision

Question 1

Will your property become trading stock in your hands under section 70-10 of the Income Tax Assessment Act 1997 (ITAA 1997) when you enter into the development agreement?

Answer

No.

Question 2

If the property would not be regarded as trading stock, would the profit on the sale of the subdivided lots constitute assessable income under section 6-5 of the ITAA 1997?

Answer

Yes.

Question 3

If the property would not be regarded as trading stock and the profit on the sale of the subdivided lots constitutes assessable income under section 6-5 of the ITAA 1997, can you use the market value of the property at the time of entering into the development agreement as your cost in calculating the profit on the sale of each subdivided lot?

Answer

Yes.

Question 4

Will the capital gains tax (CGT) provisions in Parts 3-1 and 3-3 of the ITAA 1997 apply in relation to the sale of the subdivided lots?

Answer

Yes.

Question 5

If the CGT provisions apply, will one or more of any re-zoning, planning permission, approval or subdivision of the property into lots constitute a capital improvement to the property for the purposes of Subdivision 108-D of the ITAA 1997 in relation to your pre-CGT interest in the property?

Answer

Yes.

Question 6

If the answer to question 5 is yes, then will only expenses actually paid or incurred by you in relation to such improvements be taken into account for the purposes of the improvement threshold under section 108-70 of the ITAA 1997?

Answer

Yes.

Question 7

Will your post-CGT interests in the subdivided lots be active assets under section 152-40 of the ITAA 1997 for the purposes of the small business CGT concessions during the periods of time that these interests were used by you, your affiliate or another entity that is connected with you, in the course of carrying on a business and the exceptions in subsection 152-40(4) of the ITAA 1997 do not apply?

Answer

Yes.

Question 8

If the property would be regarded as trading stock and if you choose to treat the conversion of the property into trading stock as having been effected at market value, then in relation to the capital gain arising from CGT event K4, will the capital gain in relation to your pre-CGT interest in the property be subject to CGT?

Answer

As we have determined above for Question 1 that the property will not become trading stock in your hands when you enter into the development agreement, it is not necessary to answer this question.

Question 9

If the property would be regarded as trading stock and if you choose to treat the conversion of the property into trading stock as having been effected at market value, then in relation to the capital gain arising from CGT event K4, will your post-CGT interest in the property relating to the site of the residence and adjacent land used in conjunction with the residence up to a maximum of two hectares, be eligible for the main residence exemption in Subdivision 118-B of the ITAA 1997?

Answer

As we have determined above for Question 1 that the property will not become trading stock in your hands when you enter into the development agreement, it is not necessary to answer this question.

Question 10

If the property would be regarded as trading stock and if you choose to treat the conversion of the property into trading stock as having been effected at market value, then in relation to the capital gain arising from CGT event K4, will you be entitled to use the discount method in Division 115 of the ITAA 1997 to calculate the capital gain relating to your post-CGT interest in the property?

Answer

As we have determined above for Question 1 that the property will not become trading stock in your hands when you enter into the development agreement, it is not necessary to answer this question.

Question 11

If the property would be regarded as trading stock and if you choose to treat the conversion of the property into trading stock as having been effected at market value, then in relation to the capital gain arising from CGT event K4, will you be entitled to choose the small business 15-year exemption in Subdivision 152-B of the ITAA 1997 in relation to the capital gain relating to your post-CGT interest in the property?

Answer

As we have determined above for Question 1 that the property will not become trading stock in your hands when you enter into the PDA, it is not necessary to answer this question.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The property is located in what had been almost exclusively a rural area until developers starting buying properties in the surrounding district a few years ago.

You conduct a business on the property as well as occupying the residence.

You acquired the property upon your spouse's death.

You have previously obtained advice that the acquisition of the property from your spouse would have been eligible for the CGT marriage or family breakdown rollover relief under Subdivision 126-A of the ITAA 1997.

Your use of the property has been as follows:

§ You first moved into the property as a tenant and worked with your spouse in conducting the business.

§ Your spouse was diagnosed with a medical condition, and you took over all of the responsibilities associated with the property including conducting the business.

§ You are considering entering into a development agreement with a developer for the subdivision of the property. While the development agreement provides for the property to be subdivided into a large number of residential blocks, it will likely be a few years before this will happen.

§ You are seriously contemplating whether you want to continue to run the business, and you are exploring the possibility of selling all of the assets associated with the business to a purchaser. If this were to happen, the property would only be used for agistment purposes up until completion of the development and the sales of the subdivided lots.

The property is presently within an urban growth boundary with a proposal for industrial zoning. A proposal for residential zoning was recently rejected but further submissions and lobbying are being made to have it zoned as residential.

The developer has indicated that there are likely to be a large number of lots, and as there would be a negligible cost base, you might make a substantial profit.

There was no intention to subdivide the property at the time that you acquired the property.

You are not currently, and have not previously been involved in any land developments apart from entering into the development agreement.

You do not intend to carry out any further land development in the future.

The developer has estimated that there would be substantial expenses to develop the property.

There is no other relationship between you and the developer apart from the contractual relations you would have under the development agreement.

The copy of the development agreement forwarded with your application contains the following information:

§ The developer is a member of a large group that carries on a land subdivision business.

§ The developer will carry out the development activities during the term of the agreement.

§ You will pay a development fee to the developer in consideration for the developer agreeing to develop the property.

§ Details of the services to be carried out by the developer.

The developer has made acquisitions of parcels of land virtually surrounding the property or entered into similar arrangements as those set out in the development agreement with other local land owners. You consider that if you are going to maximise the potential value of the property, then the arrangements with the developer are going to be the best way to do this.

You have also forwarded a copy of the court order in relation to the property.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 160P(6)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 70-10

Income Tax Assessment Act 1997 Subsection 70-30(1)

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 108-70

Income Tax Assessment Act 1997 Section 108-80

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 126-5

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Section 995-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Question 1

Section 70-10 of the ITAA 1997 provides that trading stock includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business.

Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

The question of whether a business is being carried on is a question of fact and degree, The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 provides the Commissioner's view of the factors used to determine if you are in business for tax purposes. In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

§ whether the activity has a significant commercial purpose or character

§ whether the taxpayer has more than just an intention to engage in business

§ whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

§ whether there is regularity and repetition of the activity

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

§ whether the activity is planned, organised and carried on in a businesslike manner such that it is described as 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 sporting activity.

No one factor is decisive. The indicator must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

Applying the above factors to your circumstances, the overall impression is that you are not carrying on a business as a property developer. You are simply entering into an agreement with a property developer for the development of your property. Apart from this agreement, you are not currently involved in any land developments. You have also not previously been involved in any land developments and you do not intend to carry out any further land development in the future. These facts indicate that you have no intention to engage in business. There is a lack of regularity and repetition of the activity as there is no trading pattern of buying, developing and selling land.

As you are not carrying on a business in relation to the subdivision and development, the property will not become trading stock in your hands under section 70-10 of the ITAA 1997 when you enter into the development agreement.

Question 2

Under section 6-5 of the ITAA 1997, your assessable income includes the ordinary income you derived directly or indirectly from all sources, during the income year.

Although the legislation does not define income according to ordinary concepts, a substantial body of case law has evolved to identify various factors that indicate the nature of ordinary income.

Taxation Ruling TR 92/3 discusses profits on isolated transactions and the application of the principles outlined in the decision of the Full High Court of Australia in FC of T v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693. This ruling states that profits on isolated transactions may be income.

Profit from an isolated transaction will be ordinary income where:

§ the intention or purpose of a 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 operation or commercial transaction.

Some factors to consider when looking at whether an isolated transaction amounts to a business operation or commercial transaction are listed at paragraph 13 of TR 92/3. They are:

(a) the nature of the entity undertaking the operation or transaction

(b) the nature and scale of other activities undertaken by the taxpayer

(c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained

(d) the nature, scale and complexity of the operation or transaction

(e) the manner in which the operation or transaction was entered into or carried out

(f) the nature of any connection between the relevant taxpayer and any other party to the operation or transaction

(g) if the transaction involves the acquisition and disposal of property, the nature of that property and

(h) the timing of the transaction or the various steps in the transaction.

In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations.

Applying the above guidelines to your circumstances

Applying the factors in paragraph 13 of TR 92/3 as listed above to your circumstances leads to the following conclusions:

(a) The nature of the entity undertaking the transaction is an individual. You will, however, be entering into a development agreement with a developer.

(b) You have never been involved in land development and you have no plans to carry out any land development in the future. Excluding the development activity, you have conducted a business on the property.

(c) The amount of money involved in the activity is significant.

(d) The scale of the activity is quite large.

(e) You will be entering into the development agreement with a developer in relation to the subdivision and development. The developer is a member of a large group that carries on a land subdivision business.

(f) There is no other relationship between you and the developer apart from the contractual relation you would have under the development agreement. This relationship is commercial in nature.

(g) The subdivision involves property which has been used for business purposes. The property is presently within an urban growth boundary with a proposal for industrial zoning. A proposal for residential zoning was recently rejected but further submissions and lobbying are being made to have it zoned as residential.

(h) You will only have owned the property for a short period prior to entering into the development agreement.

A consideration of the above factors leads to the overall impression that the subdivision and development of your property by way of entering into the development agreement with the developer is business or commercial in nature. The disposal of the subdivided lots under the development agreement would be beyond that of a mere realisation of a capital asset and would amount to an isolated profit making transaction.

The scale of the development is quite large and the amount of money involved is significant. There is a demonstrated intention to profit and the transaction will be carried out in a commercial manner.

Accordingly, the proceeds will be a profit from an isolated transaction under the guidelines of TR 92/3 as discussed above, and will be included in your assessable income as ordinary income under section 6-5 of the ITAA 1997.

Question 3

In situations where the sale of an asset is not a mere realisation, it is the net profit from the isolated transaction which will be assessable as ordinary income - see FC of T v. Whitford Beach Pty Ltd (1982) 150 CLR 355; 82 ATC 4031.

In determining the net profit that will arise from the sale of a block of land, the sale proceeds are reduced by an appropriate amount based on the market value of the block at the time the land was ventured into the profit-making scheme.

You will therefore be able to use the market value of the property at the time of entering into the development agreement in calculating the profit on the sale of each subdivided lot.

Question 4

The sale of the subdivided lots will be subject to the CGT provisions in Parts 3-1 and 3-3 of the ITAA 1997 as the sale will involve the disposal of CGT assets.

The relevant CGT asset in this case is the property. You acquired this property by a court order. The property was previously held by your spouse as a 50% pre-CGT interest and a 50% post-CGT interest. As the property was acquired by you because of a court order under a State law relating to breakdowns of relationships between spouses, the marriage breakdown same-asset roll-over in Subdivision 126-A of the ITAA 1997 will apply in your case under paragraph 126-5(1)(a) of the ITAA 1997.

Subsection 126-5(6) of the ITAA 1997 therefore provides that the interest in the property acquired by your spouse before 20 September 1985 (the pre-CGT interest) will be taken to have also been acquired by you before that date.

You will therefore hold two interests in the property, and two interests in each subdivided lot, being a pre-CGT interest and post-CGT interest in the property and each subdivided lot.

The date you acquire your interests in the subdivided lots will be the date you acquired your interests in the property, and the cost base of the original interests in the property are divided between the subdivided lots on a reasonable basis. The cost base of your post-CGT interest in the property will be determined under subsection 126-5(5) of the ITAA 1997.

Subdividing land does not result in a CGT event if you retain ownership of the subdivided lots and you will therefore not make a capital gain or a capital loss at the time of the subdivision. CGT event A1 under section 104-10 of the ITAA 1997, relating to the disposal of a CGT asset, will happen when you dispose of your interests in each of the subdivided lots.

You will make a capital gain if the capital proceeds from the disposal of each of your interests in each subdivided lot is more than the cost base of the interest. You will make a capital loss if those capital proceeds are less than the reduced cost base of the interest.

Any capital gain or capital loss in relation to the pre-CGT interests in the subdivided lots will be disregarded under paragraph 104-10(5)(a) of the ITAA 1997.

Anti-overlap provisions

Section 118-20 of the ITAA 1997 contains anti-overlap provisions which operate to reduce any capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 of the ITAA 1997 as a result of the sale, for example, as ordinary income under section 6-5 of the ITAA 1997.

Question 5

Subdivision 108-D of the ITAA 1997 relates to separate CGT assets. A capital improvement to a pre-CGT asset is taken to be a separate CGT asset in certain circumstances.

CGT Determination Number 5 TD 5 states that intangible (non-physical) improvements are taken to be improvements of a capital nature for the purposes of former subsection 160P(6) of the Income Tax Assessment Act 1936 (ITAA 1936) and gives improvements such as council approval to rezone and subdivide land as an example. As subsection 108-70(2) of the ITAA 1997 is one of the corresponding provisions for former subsection 160P(6) of the ITAA 1936, this CGT Determination would also apply to the current provision.

The re-zoning, obtaining planning permission, approval or subdivision will therefore be capital improvements for the purposes of Subdivision 108-D of the ITAA 1997.

Question 6

Subsection 108-70(2) of the ITAA 1997 applies to unrelated improvements to pre-CGT assets while subsection 108-70(3) of the ITAA 1997 applies to related improvements to pre-CGT assets, and provide that a capital improvement to a pre-CGT asset is taken to be a separate CGT asset in certain circumstances.

Section 108-80 of the ITAA 1997 states that in deciding whether capital improvements are related to each other, the factors to be considered include:

(a) the nature of the CGT asset to which the improvements are made, and

(b) the nature, location, size, value, quality, composition and utility of each improvement, and

(c) whether an improvement depends in a physical, economic, commercial or practical sense on another improvement, and

(d) whether the improvements are part of an overall project, and

(e) whether the improvements are of the same kind, and

(f) whether the improvements are made within a reasonable period of time of each other.

In your case, we would consider the rezoning, obtaining planning permission, approval or subdivision to be related improvements as these all involve the subdivision of the same property, the improvements are part of the same overall project, are of a similar nature and would be made within a reasonable period of time of each other.

The relevant provision to be considered for the purposes of this question will therefore be subsection 108-70(3) of the ITAA 1997 applying to related improvements. This provision states that capital improvements to a CGT asset that you acquired before 20 September 1985 that are related to each other are taken to be a separate CGT asset if the total of their cost bases (assuming each one were a separate CGT asset) when a CGT event happens in relation to the original asset is:

(a) more than the improvement threshold for the income year in which the event happened; and

(b) more than 5 per cent of the capital proceeds from the event.

Section 110-25 of the ITAA 1997 provides the general rules about cost base. All five elements of the cost base under this provision require that you pay money (first element) or incur costs or expenditure (second to fifth elements) for the cost or expenditure to be included in the cost base.

Therefore, only money paid, or costs and expenditure incurred by you in relation to the re-zoning, obtaining planning permission, approval or subdivision will be included in the cost bases for these improvements for the purposes of determining whether the improvement threshold requirement in subsection 108-70(3) of the ITAA 1997 is satisfied.

You will need to allocate the costs of subdivision to your pre-CGT and post-CGT interests in the subdivided lots. Provided that the costs of subdivision that apply to each of your pre-CGT interests in each subdivided lot is less than the improvement threshold for the income year in which the CGT event happens and 5 per cent of the capital proceeds from the disposal of that pre-CGT interest, then the capital improvement will not constitute a separate asset under subsection 108-70(3) of the ITAA 1997.

Question 7

The active asset test in section 152-35 of the ITAA 1997 is satisfied if:

(a) you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period detailed below or

(b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 ½ years during the period detailed below:

The period:

(a) begins when you acquired the asset and

(b) ends at the earlier of:

(i) the CGT event and

(ii) if the relevant business ceased in the 12 months before the CGT event (or such longer time as the Commissioner allows) when the business ceased.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, your affiliate, or by another entity that is connected with you, in the course of carrying on a business.

Paragraph 152-40(4) of the ITAA 1997 contains exceptions to the above. Paragraph 152-40(4)(e) of the ITAA 1997, in particular, states that a CGT asset whose main use in the course of carrying on the business is to derive rent, can not be an active asset.

As any capital gain made by you in relation to the disposal of your pre-CGT interests in the subdivided lots will be disregarded under paragraph 104-10(5)(a) of the ITAA 1997, the small business CGT concessions will have no application to the pre-CGT interests, and it is not necessary to consider the active asset test in relation to these interests.

The post-CGT interest in the property, and in each subdivided lot, will be acquired by you when the property is transferred to you (paragraph 104-10(3)(b) of the ITAA 1997), and this will be the relevant commencement date for the purposes of the active asset test in relation to these interests.

Your post-CGT interests in the property and subdivided lots will therefore be active assets for the purposes of the small business CGT concessions during the period of time that these interests were owned by you and used by you, your affiliate, or by another entity that is connected with you in the course of carrying on a business and the exceptions in subsection 152-40(4) of the ITAA 1997 do not apply. If these requirements are satisfied, you will be able to apply the small business CGT concessions provided any other relevant conditions for the concessions are satisfied.

Note

1. The definition of 'active asset' does not require exclusive use of the asset for business purposes. Your interests in the property can still be active assets even if your interests were to be greater than the business use of the interests, such as part of the interests being used for the residence.

2. Agisting livestock does not ordinarily constitute the carrying on of a business. However, where a land owner is charged with the management, maintenance and care of the animals agisted then it is possible that the person is carrying on a business (AAT Case 10,331; 95 ATC 404; (1995) 31 ATR 1146).

Question 8 to 11

As we have determined above for question 1 that the property will not become trading stock in your hands when you enter into the development agreement, it is not necessary to answer these questions.