Edited version of your private ruling

Authorisation Number: 1012459233320

Ruling

Subject: Carrying on a business

Question 1

Is the company considered to be a carrying on a business for the purposes of Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If the company is carrying on a business, is the asset sold considered to be an active asset under section 152-40 of the ITAA 1997?

Answer

No

This ruling applies for the following periods

1 July 20YY to 30 June 20ZZ

The scheme commences on

1 July 20YY

Relevant facts and circumstances

You advise that the entity was formed as a company with the intention of buying and selling property, developing property, holding property and deriving rental income prior to optimum timing for resale and holding various other investments such as dividends and interest bearing cash deposits.

Property A was purchased by the company and some years later several townhouses were constructed and subsequently leased on the residential market. Property A remains an asset of the company delivering profitable revenue return for it.

Property B - (the subject of the private ruling request), was also purchased by the company in the same year.

Zoned medium density development, the land size would permit the development of several town houses, a potentially profitable project. The company did not have the funds to complete the development at the time so the property was rented. When the adjoining property (property C) became available (thus expanding the development potential) it was purchased. The company also engaged with neighbouring property owners to combine properties for a larger development.

Continued efforts to raise finance for the town house development were unsuccessful and the project was postponed. Council subsequently changed the building to land ratio making the development risk to reward too high. The company decided to sell property C.

Property B remained rented with the hope that council may eventually modify the land to building ratio. A strategic business decision was made to sell property B in 20ZZ and invest funds elsewhere.

Property B was leased on a long term basis with a real estate agent being hired to:

· advertise

· appoint tenants

· collect the rent

· oversee necessary repairs and

· clean the premises.

There were no other services provided by the owners and they visited the premises annually.

One of the company directors is a qualified property valuer.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-5

Income Tax Assessment Act 1997 section 152-40

Reasons for decision

Question 1

Summary

The company is not currently carrying on a business.

Detailed reasoning

Division 152 of the ITAA 1997 provides relief for small businesses from the imposition of capital gains tax imposed on the disposal of capital assets utilised in carrying on that business. For the relief to be available it must be first established that a business is being carried on.

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 to determine the matter, these indicators are summarised in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production. These indicators are applicable to business activity generally.

The following indicators are relevant:

· 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 repetition and regularity of the activity

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

· whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit and

· the size, scale and permanency of the activity

The company was formed with the intention to buy, sell and develop property, however for a business to be considered to be conducted it is not enough to have the intention to engage in business there must be a demonstrated participation in the business activity. Property B which has been sold as well as property A which is held by the company were both acquired many years ago. Apart from the development which was undertaken on property A there has been no participation in developing properties. Property A was developed but held for rental and there has been one other purchase and sale of a single property (property C) in the ensuing period.

There has been no repetition and regularity of the activity of buying and selling property, and property development. There has, however, been regularity and significant commercial purpose and profit derived from the other intention of forming the company. This intention was holding property and deriving rental income prior to optimum timing for resale.

There have been many court cases regarding whether the activities relating to holding property and deriving rental income amount to the carrying on of a business.

In Federal Commissioner of Taxation v. McDonald (1987) 15 FCR 172; 87 ATC 4541; (1987) 18 ATR 957 (McDonald's Case) it was found that the taxpayer and his wife, who owned two investment properties, were not carrying on a business; their relationship was that of co-ownership rather than partnership. There was a mere investment in property rather than a partnership in the properties or their profits.

The principle from McDonald's Case was followed in Cripps v. FC of T 99 ATC 2428; (1999) 43 ATR 1202 (Cripp's Case). In Cripp's Case the taxpayer and his wife purchased as joint tenants 14 double storey townhouses. The acquisition was financed entirely by borrowed funds, which were secured by a mortgage over the properties. After renovations, the townhouses were rented out. They were managed by a real estate agent. Substantial tax losses were incurred over a number of years in respect of the properties. The taxpayer allocated full losses to himself on the basis that a general law partnership existed (which implied that a business was being carried on). Objections to the Commissioner's decisions were disallowed and the taxpayer appealed.

The taxpayer contended that the acquisition and renting out of the properties by him and his wife constituted the carrying on of a business. The taxpayer supported his contention by pointing to the use of a business name by he and his wife, the existence of a business plan, his involvement in the management of the townhouses and the number of properties involved. The Commissioners decision was upheld, it was ruled that the arrangement between the taxpayer and his wife was merely that of an investment and not a business.

Similarly, in Carson & Anor v. FC of T [2008] AATA 156; (2008) 2008 ATC 10-006; (2008) 71 ATR 301 (Carson's Case) the taxpayers purchased a rental unit which they used to provide short-term tourist accommodation, usually for stays of about one to two weeks.

The taxpayers engaged a real estate agent to arrange rentals and to attend to minor repairs. The taxpayers spent around one week every six months servicing the unit and attending to the surrounding garden. According to the taxpayers, the unit had an average annual turnover of $35,000, and they undertook activities in relation to the unit such as dealing with financial institutions in relation to loans and financing, dealing with rating authorities and body corporate matters, and maintaining proper accounting and tax records.

The taxpayers sought a private ruling confirming that the unit was an active asset for the purposes of the small business CGT concessions. The Commissioner ruled that the unit was not an active asset as a business was not being carried on. Their objection was also disallowed.

The case was appealed in the Administrative Appeals Tribunal. At issue was whether the unit was used in the course of carrying on a business and whether the unit was disqualified from being an active asset by having its main use to derive rent. In regard to the latter, the taxpayers relied on Taxation Determination TD 2006/78 (TD 2006/78) Income tax: capital gains: are there any circumstances in which the premises used in a business of providing accommodation for reward may satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 notwithstanding the exclusion in paragraph 152-40(4)(e) of the Income Tax Assessment Act 1997 for assets whose main use is to derive rent? This determination indicated that certain premises used in a business of providing accommodation for reward would satisfy the active asset test.

The taxpayers' activities had many indicators of maintaining and deriving income from an investment rather than the carrying on of a business. Activities such as financing the property, dealing with rating authorities and maintaining accounting and tax records were no more than any investor in real estate would do. They were not the sustained, repetitive commercial activities representing the carrying on of a business activity. The Commissioners decision was upheld.

In your case a real estate agent was engaged to administer the day to day requirements of running a business of renting properties including advertising for and appointing tenants, collecting rent, overseeing repairs and any other requirements. The relationship between the company and the occupants of the house which was sold was that of landlord/tenant under a lease agreement. There were no services provided by the company to the tenants other than the right to occupy the premises.

Therefore, similar to Carson's case the occupants would consider that they were renting the premises consequently the income derived would correctly be considered to be 'rent'.

The rental activities had:

· significant commercial purpose and character,

· an obvious profit motive and

· there are clearly others who carry out similar activities

As a result, your property activities are not considered to amount to the carrying on of a business of buying and selling property, developing property, holding property or deriving rental income. It is the lack of involvement in the rental properties which characterises the income as passive in nature.

The demonstrated commercial purpose of the property activities conducted by the company is to derive rental income. This is verified by the repetition and regularity of the income derived over a long period of time.

Similar to McDonald's Case, Cripp's Case and Carson's Case the company's property activities when considered objectively are properly described as passive investments.

Question 2

Summary

The company's property is not held in the course of carrying on a business however, even if the company had been determined to be carrying on a business of buying and selling property, developing property, holding property or deriving rental income, the property which was sold could not be defined as an active asset.

Detailed reasoning

Subsection 152-40(4) of the ITAA 1997 states that an asset used mainly by you to derive rent cannot be described as an active asset unless the asset is an intangible asset and has been substantially developed, altered or improved by you so that its market value has been substantially enhanced or its main use for deriving rent was only temporary.

The following example is given:

A company uses a house purely as an investment property and rents it out. The house is not an active asset because the company is not using the house in the course of carrying on a business. If, on the other hand, the company ran the house as a guest house the house would be an active asset because the company would be using it to carry on a business and not to derive rent.

In TD 2006/78 there are examples where the engagement of the owners of a commercial storage facility, a boarding house and holiday apartments has been sufficient to demonstrate that, if the activities are sufficient to warrant that a business is being conducted that the properties involved would be considered to be active assets in those businesses. For example the holiday apartment owner carried out bookings, checking in guests, cleaning apartments, providing linen and meals for guests. The relationship between the guests and the owner were not that of a landlord/tenant and the payment received was not in the nature of 'rent'.

Your company owned a property which is not used in the course of carrying on a business and the income derived from the property can correctly be described as rent therefore the asset does not pass the 'active asset test' in accordance with section 152-40 of the ITAA 1997.