Edited version of your written advice

Authorisation Number: 1012701682357

Ruling

Subject: Apartment development from rental property

Question:

Where you originally acquired a single storey commercial rental property on capital account and subsequently develop a multi-storey apartment building on the property, will the proceeds received from the development constitute ordinary income?

Answer:

Yes

This ruling applies for the following periods:

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commences on:

1 July 2014

Relevant facts and circumstances

You jointly acquired a single storey commercial property with the understanding the existing tenant would renew its lease. However, the tenant gave notice of their intention to vacate and, since then, you have been unable to find new tenant, despite lowering the rent.

Given you were under pressure holding the property without rental income, you engaged an architect (who you met in your search for tenants) to prepare a feasibility study on the site. After liaising with the local council, you now have a feasibility plan that can practically and profitably realise the full potential of the property by building residential apartments. The development cost will be around four times your original acquisition cost.

As you are not in a financial position to hold the property for rental income after building the apartments, you anticipate selling the apartments.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Reasons for decision

Profits from a property development can be treated for taxation purposes in three ways:

(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 land as trading stock.

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

(3) As statutory income under the capital gains tax (CGT) legislation, (sections 10-5 and 102-5 of the ITAA 1997), as a result of the mere realisation of a capital asset.

The term 'business' ordinarily refers to trade engaged in on a regular or continuous basis. Whereas an isolated (one-off) commercial transaction does not amount to a business but has the characteristics of a 'business deal'.

Taxation Ruling TR 92/3 explains, for an isolated commercial transaction to occur, it is usually (but not always) necessary the taxpayer has the purpose of profit-making at the time of acquiring the property and that the property has no use other than as the subject of trade.

In Commissioner of Taxes v Melbourne Trust Limited [1914] AC 1001, the mere realisation of a capital asset was described as "liquidating or realising the old assets".

In the High Court of Australia case of Federal Commissioner of Taxation v NF Williams (1972) 72 ATC 4188, Gibbs J explained mere realisation of land as follows:

An owner of land who holds it until the price of land has risen and then subdivides and sells it is not thereby engaging in an adventure in the nature of trade, or carrying out a profit-making scheme. The situation is not altered by the fact that the landowner seeks and acts upon the advice of an expert as to the best method of subdivision and sale or by the fact that he carries out work such as grading, levelling, road-building and the provision of reticulation for water and power to enable the land to be sold to its best advantage. The proceeds resulting from the mere realization of a capital asset are not income either in accordance with ordinary concepts…even though the realization is carried out in an enterprising way so as to secure the best price…

In the Federal Court of Australia case of Casimaty v Federal Commissioner of Taxation 97 ATC 5135, at 97 ATC 5152, Ryan J distinguished a mere realisation from a commercial transaction as follows:

Nor did the taxpayer undertake any works on, or development of, the land beyond what was necessary to secure the approval by the municipal authorities of the successive plans of subdivision and enhance the presentation of individual allotments for sale as vacant blocks. Had he constructed dwelling houses, internal fencing or other improvements, it would have been easier to impute to him an intention to carry on a business of land development and improvement.

In Casimaty, Ryan J also discussed the matter of financing a commercial development, referring to Stevenson v FC of T 91 ATC 4476; (1991) 29 FCR 282, where it was held: "not only obtaining finance but risking finance" and referring to Turner v Last (HM Inspector of Taxes) (1965) 42 TC 517, where the financial inability to hold the land indefinitely lead to the determination the land was purchased for development rather than for investment.

In your case, although you possibly purchased your property as an investment, the development works you are consider go far beyond the mere realisation or a renovation of a capital asset because you will demolish a single storey dwelling to construction a multi-storey apartment building. Further, when the new apartments are built (and thus acquired) they will have no use other than as the subject of trade (per paragraph 49(g) of TR 92/3). Also, you will not only obtain finance but also risk finance given what you borrow to construct the apartments will be far more than the unimproved value held in the land.

This outcome is affirmed in the judgment of Casimaty, which held the construction and sale of new dwelling houses on land plus the risking of finance is a commercial (business) venture.