Edited version of private advice

Authorisation Number: 1012627896102

Ruling

Subject: Sale of Building

Question 1

Will the proceeds from the sale of the commercial building be assessable under Part 3-1 Capital Gains and Losses of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

1 July 2013 to 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A nominee company acquired the development site and held it as bare trustee on behalf of the beneficiaries being the Taxpayer and his business partner.

The Trust Deed brought into existence a joint venture whereby the parties would provide 50% of the outgoings and hold 50% of the trust estate as tenants in common.

The development site was acquired pursuant to a contract of sale a number of years ago.

As part of the contract of sale, the seller was allowed to occupy the building and call for settlement by a certain date.

Settlement of the property occurred a number of years later.

During the period between exchange and settlement, the owners completed Design and Concept drawings, plus obtained approval for their development application and building approval.

In late 200x a fixed price building contract was agreed to building a commercial building.

The estimated cash flow from a fully leased building would be sufficient to support interest repayments on the loan.

Finance for the acquisition of the development land and construction of the building was obtained initially for the period of construction and was able to be extended for a further 5 years subject to compliance with loan covenants.

Tenants first occupied the building in early 200y.

The building was fully tenanted with terms ranging from x to yy years in duration.

The taxpayer has a history of property development, including the construction and sale of residential apartments to third parties.

The Taxpayer also has a history of acquiring and developing commercial property to be held for medium to long term lease.

The building was sold late in the recent year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5,

Income Tax Assessment Act 1997 section 10-5,

Income Tax Assessment Act 1997 section 102-5 and

Income Tax Assessment Act 1997 Part 3-1 Capital Gains and Losses.

Reasons for decision

Taxation treatment of property sales

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

 (1) As ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), on revenue account, as a result of carrying on a business of property development, involving the sale of property as trading stock.

 (2) As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of an isolated business transaction entered into by a non-business taxpayer or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose.

 (3) As statutory income under the CGT legislation, (sections 10-5 and 102-5 of the ITAA 1997), on the basis that a mere realisation of a capital asset has occurred.

A gain from the disposal of property will be stamped with the character of income where:

1. it is made in the ordinary course of carrying on a business; that is, where "what ... is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business": California Copper Syndicate v Harris (1904) 5 TC 159 at pp.165-166; and London Australia Investment Company Limited v Commissioner of Taxation (1976-1977) 138 CLR 106;

2. it is made outside of the ordinary course of a taxpayer's business from an isolated (or "extraordinary") transaction entered into with the intention or purpose of making a profit. (This is the so-called first limb or strand of the decision in Commissioner of Taxation v The Myer Emporium Ltd (1987) 163 CLR 199 at pp.209-210); or

3. it is made from an isolated or one-off business venture or profit-making scheme: Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355.

In respect of isolated or one-off business ventures or profit making schemes, Taxation Ruling TR 92/3 (TR 92/3) at paragraphs 33 - 36 state:

33. The views expressed in Whitfords Beach and Myer that profits from isolated transactions can be assessable income must be looked at in the context of the facts involved in those cases. In Myer, the taxpayer was carrying on a large business at the time it entered into the transactions and, in Whitfords Beach, the taxpayer company embarked on a substantial business venture.

34. Nevertheless, there is a strong line of reasoning through the judgments in Whitfords Beach and Myer that suggests that profits made by a taxpayer who enters into an isolated transaction with a profit-making purpose can be assessable income. In Myer, at 163 CLR 213; 87 ATC 4369; 18 ATR 699-700, the Full High Court had this to say about the nature of profits from isolated transactions:

'It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realisation. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.'

35. A profit from an isolated transaction is therefore generally assessable income when both of the following elements are present:

(a)  The intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain.

(b)  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.

36. The courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. The expression 'mere realisation' is used to contradistinguish a business operation or a commercial transaction carrying out a profit-making scheme (Myer at 163 CLR 213; 87 ATC 4368-4369; 18 ATR 699-700). If a transaction satisfies the elements set out in paragraph 35 it is generally not a mere realisation of an investment.

From the above it can be concluded that where there was an intention from the outset to sell a property development at a profit and where the property development is made in the course of carrying on a business or as a commercial transaction, these activities are of a revenue nature and therefore assessable under section 6-5 of the ITAA 1997.

To determine whether the sale of the building is revenue or capital we need to consider the following:

• Did the sale form part of the Taxpayer's ordinary business activities?

• At the time of purchase was there a profit making purpose?

Did the sale form part of the Taxpayer's ordinary business activities?

The building was purchased using a nominee company as bare trustee on behalf of Trust A and Trust B. The Taxpayer was a beneficiary of Trust A and the business partner a beneficiary of Trust B. This was a typical structure used by the taxpayer and his business partner for all their joint property developments. The purpose of using this structure for each development was to minimise risks and also as a way for each partner to extract profits from the partnership.

As stated in the facts, the Taxpayer's property activities can be distinguished into two different categories, including:

• The purchase of land, the development of residential apartments and the sale of these to third parties; and

• The purchase of land or commercial property, the development or redevelopment of the land or buildings into commercial offices and the lease of these to third parties.

The Taxpayer's activities involving the development of residential apartments and the sale of these to third parties have been the Taxpayer's main mode of business operation. It is considered that these activities have all the characteristics of a business including a profit making purpose and are considered to constitute the Taxpayer's ordinary business operations.

The Taxpayer also has a history of purchasing and developing commercial buildings and the leasing of these to third parties. The Taxpayer contends that having high quality assets on their Balance Sheets with quality tenants is seen positively by financiers and allows them to pursue other investment opportunities. It is considered that these projects entered into are not part of the Taxpayer's ordinary business operations.

It can be concluded that the building development the subject of this ruling was not part of the Taxpayer's ordinary business activities.

At the time of purchase was there a profit making purpose?

Where a profit making activity is a one off or isolated transaction and not part of the Taxpayer's ordinary business activities, the activities may still be revenue in nature and assessable under section 6-5 of the ITAA 1997 where at the time of purchase there was a profit making purpose.

When considering the intentions of a Taxpayer at the time of acquiring the land or a property development, paragraph 38 of TR 92/3 states:

38. The intention or purpose of the taxpayer (of making a profit or gain) referred to in Myer 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. This is implicit from what the Court said, in the passage quoted in paragraph 30 above:

'..it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income..'.

When considering intention, it is the intention of those who control the entity acquiring the land or development. In this case the persons who control and make the decisions in respect of the property were both the Taxpayer and his business partner equally.

When considering the Taxpayer's intention or purpose from an objective analysis of the facts it can be concluded that:

• The Taxpayer has a history of acquiring land or commercial property and holding these for lease over a medium to long term period;

• The Taxpayer acquired the property as a development site some years ago, and valuations suggest that the best way to realise its potential was to build a commercial office building (note that the Taxpayer could have resold the development land at a profit but chose not to);

• during the period between when the Taxpayer entered into the contract to purchase and the date of settlement, the Taxpayer commenced the following activities:

• Instigated the design and concept drawings and obtained approval for the development application as well as the building approval;

• Finance was arranged which allowed the property to be retained for a period of 5 years following construction subject to compliance with loan covenants; and

• Entered into a fixed price building construction contract a number of years later to build a commercial building;

• The Taxpayer sought out quality tenants for the building and entered into leases ranging from x years to yy years in duration (with options to extend);

• The property commenced being tenanted in early 200x; and

• The Taxpayer set aside sufficient cash reserves to hold the property for the long term and made sure it satisfied the bank covenants to have the bank loan extended for a further 5 years. The cash flow from leasing income was enough to support the interest payable under the bank loan.

Following the completion of the building, the Taxpayer received further valuation reports to assess the value of the building and the rental market. The report showed that the market value of the building had decreased and rental vacancies had increased as a result of the global financial crisis (GFC). The Taxpayer continued to hold and lease the building despite increased risks of its capital and cash flow decreasing.

In the middle of the recent year, over three years after the construction and commencement of leasing the building, the Taxpayer made the decision to seek expressions of interest to sell the building. The reasons provided were:

• Both the Taxpayer and his business partner commenced divesting their joint interests and had made the decision to cease entering into new investments and developments together, due to each family wanting to develop a business succession plan;

• Following the GFC, property prices had recovered somewhat, however the risks of a softening economy, increasing vacancy rates, decreasing rents meant the risks of holding the building had increased;

• Leasing office space was becoming more competitive with the planned construction of new office buildings being due for completion at the time leases were coming up for renewal;

• The risk profile of the building was trending towards medium/high for the Taxpayer and his business partner based on the current and likely future market conditions as well as the fact that the asset had appreciated significantly and it now formed a significant part of their wealth and was deemed too high of a risk to retain.

The building was sold late in the recent year.

From the above objective analysis of what the Taxpayer's did upon acquiring the property through to the construction, leasing and eventual sale of the property it is evident that the Taxpayer did not have the primary intention to make a profit on the development from the outset. The facts demonstrate that following the purchase of the development site, the Taxpayer had the intention to construct and lease a commercial building for the medium to long term and indeed did follow through with this plan.

The Commissioner considers that the circumstances surrounding the eventual sale of the property indicate that the Taxpayer and his business partner's decision to sell the property constitutes a mere realisation of a capital asset and was not connected with any intention to sell the property from the outset as a profit making activity.

Conclusion

The proceeds from the sale of the building will be assessable under Part 3-1 Capital Gains and Losses of the ITAA 1997.