Edited version of your written advice

Authorisation Number: 1012895491199

Date of advice: 16 October 2015

Ruling

Subject: Am I carrying on a business? Capital gains tax whether rental properties leased to tenants can be active assets

Issue 1

Question 1:

Are you and your spouse carrying on a business of letting rental properties?

Answer 1:

No.

This ruling applies for the following period:

30 June 20YY.

The scheme commences on:

1 July 20XX.

Issue 2

Question 1:

Was the sale of your rental property in the 20XX-YY income year, the sale of an active asset?

Answer 1:

No.

This ruling applies for the following period:

Year ended 30 June 20YY.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

You and your spouse have jointly owned properties for the following periods. The properties have been rental properties except for the various periods, or where they were your main residence, also noted.

Three rental properties were owned by you at various stages during the year ended 30 June 20YY.

You have received the following rental income:

You both work full time.

You have engaged rental property agents to manage the rental properties.

You have said that you are heavily engaged in property securing finance, inspecting the properties, seeking insurance cover, maintaining the properties when vacated, reviewing the interest, insurance and property markets taking you less than 25 hours each per week in total.

In summary in the year ended 30 June 20YY:

• you jointly owned less than five rental properties, one was sold, one became your main residence and the other property was the only rental property available for rent for the whole year, it was later sold in the year ended 30 June 20ZZ; and

• The total asset value of rental properties at the beginning of the financial year was less than five properties compared to one at the end of the financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 paragraph 152-40(1)(a)

Income Tax Assessment Act 1997 paragraph 152-40(4)(e)

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Issue 1

Question 1

Summary

You are not carrying on a business of letting rental properties. It is considered that the scale of activity and volume of operations carried on by you is insufficient to be considered as carrying on a business.

Detailed reasoning

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that your assessable income includes income according to ordinary concepts. This 'ordinary income' includes amongst other things, income from salary and wages and business operations.

Section 8-1 of the ITAA 1997 allows you to claim a deduction for a loss or outgoing that is incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business to gain or produce assessable income. These deductions are limited by the exclusion of losses or outgoings that are capital, private or domestic in nature.

Carrying on 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'.

Normally the receipt of income from the letting of property to a tenant(s) does not amount to the carrying on of a business (Wertman v. Minister of National Revenue (1964) 64 DTC 5158; Federal Commissioner of Taxation v. McDonald (1987) 15 FCR 172; 87 ATC 4541; 18 ATR 957 (McDonald's Case); Cripps v. FC of T 99 ATC 2428 (Cripps' Case); Case X48 90 ATC 384; (1990) 21 ATR 3389). 

Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case, (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159). Generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual ((paragraph 3 of Taxation Ruling No. IT 2423 Withholding tax: whether rental income constitutes proceeds of business - permanent establishment - deduction for interest (IT2423)).

A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities. A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations. If rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business (paragraph 5 of IT 2423).

The issue of whether individuals are carrying on a business of letting property has been considered in a number of cases, some of which are discussed below.

In Cripps v. FC of T 99 ATC 2428; (1999) 43 ATR 1202, the taxpayer and his wife purchased, as joint tenants, 14 townhouses which they rented out. They also purchased a property which was used initially as a holiday home but was later periodically rented out. A further property was purchased for residential purposes. After a failed attempt to sell it, it was also rented out. The Administrative Appeals Tribunal found that the taxpayer and his wife were mere passive investors and were not in the business of deriving income from rental properties. They rejected the taxpayer's argument that he had greater involvement with his 16 properties.

In 11 CTBR (OS) Case 24 (Case 24), the taxpayer's income included rents from three properties. The taxpayer employed a manager and an accountant - he was principally a letting clerk with authority to refuse tenants. He collected and banked rents, attended to repairs and supervised them, and controlled the caretaker and cleaners. He kept books in connection with rents and repairs, and rates and other outgoings. The taxpayer said he personally carried out the principal part of the management of his rent-producing properties and directed policy, attended to the financial arrangements and made decisions regarding repairs. The taxpayer claimed that he was carrying on a business. In holding that he was not carrying on a business, a majority of the members of the Board of Review said:

It is obvious that some measure of supervision and management must ordinarily be exercised by a property owner who lets offices, &c., and if that does not amount to the carrying on of a business, the fact that he employs others to assist him, either in the letting of the properties or in the preparation of the accounts relating to his rents and outgoings, will not make any difference. For the foregoing reasons we are unable to uphold the claim that the taxpayer is engaged in a 'business as property owner'....

In 15 CTBR (OS) Case 26, (Case 26) the taxpayer derived income substantially from her joint ownership of a block of flats (containing 22 living units) with her sister-in-law. A swimming pool was shared with a neighbouring block of flats owned by the taxpayer's husband and his brother. A garden was maintained and a staff of one caretaker and one cleaner employed on both buildings with casual labour as required. The building was erected and financed by F & Co., the husbands of the joint owners, in the course of their business as building contractors. The general supervision of letting, rent collecting, servicing and maintenance was carried out by the owners or by F & Co. on their behalf. No charge was made by F & Co. for the extensive assistance given in the supervision of the flats. It was held that a business was not being carried on by the owners of the block of flats.

On the other hand, Case G10 75 ATC 33 (Case G10), the taxpayer owned two properties of which six units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a seven day a week activity. The Board of Review held that the activity constituted the carrying on of a business.

In the Rental Properties guide published by the Australian Taxation Office the Commissioner sets out two examples that discuss the issue of whether or not the owner of one or more rental properties can be said to be carrying on a business. These two examples are set out on page 3 of the guide.

The first example outlines a situation in which the owners are not carrying on a rental property business. The Commissioner states:

The Tobin's own, as joint tenants, two units and a house from which they derive rental income. The Tobin's occasionally inspected the properties and also interview prospective tenants. Mr Tobin performs most repairs and maintenance on the properties himself, although he generally relies on the tenants to let him know what is required. The Tobin's do any cleaning or maintenance that is required when tenants move out. Arrangements have been made with the tenants for the weekly rent to be paid into an account at their local bank. Although the Tobin's devote some of their time to rental income activities, their main sources of income are their respective full-time jobs.

The Tobin's are not partners carrying on a rental property business - they are only co-owners of several rental properties.

The second example outlines a situation in which the owners are carrying on a rental property business. The Commissioner states:

The D'Souza's own a number of rental properties, either as joint tenants or tenants in common. They own eight houses and three apartment blocks - each block comprising six residential units - a total of 26 properties.

The D'Souza's actively manage all of the properties. They devote a significant amount of time - an average of 25 hours per week - to these activities. They undertake all financial planning and decision making in relation to the properties. They interview all prospective tenants and conduct all of the rent collection. They carry out regular property inspections and attend to all of the everyday maintenance and repairs themselves or organise for them to be done on their behalf. Apart from income Mr D'Souza earns from shares, they have no other sources of income.

The D'Souza's are carrying on a rental property business. This is demonstrated by:

• the significant size and scale of the rental property activities;

• the number of hours the D'Souza's spend on the activities;

• the D'Souza's extensive personal involvement in the activities; and

• the business-like manner in which the activities are planned, organised and carried on.

The Commissioner has formed the view that your situation is closer to the Tobin example than it is to the D'Souza's example. While the Commissioner recognises that you are involved in some of the management of your rental properties, the size and scale of your activities is not as significant as those undertaken by the D'Souza's.

Taxation Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? (TR   97/11) provides the Commissioners view of the factors used to determine if a taxpayer is in business for tax purposes. Its principles are not restricted to questions of whether a primary production business is being carried on.

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.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case.

As shown in the above cases and the views of the Commissioner listed above, the indicators with the greatest weighting are the scale or volume of operations and the repetition and regularity of the activities.

Applying the relevant cases and indicators to your circumstances

Significant commercial purpose

The 'significant commercial purpose or character' indicator is closely linked to the other indicators and is a generalisation drawn from the interaction of the other indicators. It is particularly linked to the size and scale of activity, the repetition and regularity of activity and the profit indicators.

In the year ended 30 June 20YY, of the rental properties owned, there was only one property that was rented for the whole year (this rental property was later sold in the year ended 30 June 20ZZ), one rental property was sold during the year and the other rental property became your main residence during the year.

The total gross rental income was a certain amount; and

The total asset value of rental properties at the beginning of the financial year was a certain amount and the total asset value of rental properties at the end of the financial year was significantly less.

At the end of the year there was one rental property, this does not indicate that a business of letting rental properties was being carried on.

Intention of the taxpayer

The carrying on of a business is not a matter merely of intention; it is a matter of activity. It is appropriate to look at when the activities started and whether they add up to more than a mere intention to conduct a business.

Whilst in earlier years you owned on average less than five rental properties, in the year ended 30 June 20YY, the size and scale of the activity was decreasing.

Prospect of profits

The taxpayer's involvement in the business activity should be motivated by wanting to make a tax profit and the taxpayer's activities should be conducted in a way that facilitates this. This will require examining whether objectively there is a real prospect of making such a profit from participating in the business of the taxpayer.

The facts provided have not indicated whether or not the activity was profitable or operating at a loss.

Repetition and regularity

The taxpayer's activities should involve repetition and regularity and have an air of permanence about them. With regards to letting of properties, repetition and regularity may be measured by factors such as regularity of maintenance, collecting of rent, management and advertising of the properties, insurance, dealing with tenancy agreements and inspection reports.

You have stated that property agents manage the rental properties. Whilst you have advised that you have a personal contact with your bank manager and that you are in constant contact with them and that you are involved in maintenance and repairs, and various other activities. Given that the property managers would manage the renting of the property, some of the activities undertaken by you would apply equally to an investor any property owner.

The level of repetition and regularity of the activity is not as great as that noted in Case 26. In this case, despite the management and maintenance activities undertaken, the property owners were not considered to be carrying on a business of letting properties.

Activities of the same kind and carried on in a similar manner to those of the ordinary trade in that line of business

If a taxpayer carries out their activity in a manner similar to other taxpayers in the industry, it is more likely that their activity amounts to the carrying on of a business. That is, the taxpayer's operations are of the same kind and carried on in the same way as those characteristic of ordinary trading in that particular line of business (IR Commissioners v. Livingston 11 TC 538).

This indicator requires a comparison between the activities of the taxpayer in question and those undertaken by a person in business in the same type of industry. Where the taxpayer's activities are similar in nature to the business, further support is given to the fact that a business exists.

Generally, where the property owners grant exclusive possession of the property to the residents the relationship between the two parties is one of tenant and landlord, and the activity is more likely to be passive investment rather than a business. Similarly, activities constituting the mere maintenance of an asset and the mere collection of income do not indicate the existence of a business of renting premises.

You were renting the properties; therefore the relationship is that of a landlord and tenant.

Organisation in a business-like manner, the keeping of books, records and the use of a system

The activities conducted by, or on behalf of the taxpayer, should be carried out in a systematic and organised manner. This will usually involve matters such as the keeping of appropriate business records by the taxpayer. If the activities are carried out on the taxpayer's behalf by someone else, there should be regular reports provided to the taxpayer on the results of those activities.

You have stated that you have engaged agents to manage the properties.

The size and scale of the activity

The business should be large enough to make it commercially viable. In Cripps' Case, it was held that the renting of 14 two storey townhouses was not a business and in McDonald's Case it was held that the letting of two units in different strata plans was also not a business. Similarly in Cases 24 and 26 the renting of 22 units and three properties respectively was also not considered a business.

The scale of your activities and volume of operations can be distinguished from the cases noted above as there were less than five properties and some were not rented for the whole year due to sale or becoming your main residence.

Hobby or recreation

The activity does not have the nature of a hobby or recreational pursuit. The nature of the activity is similar to other rental property owners who are actively involved in some aspect of the property they own.

Conclusion

In this case, it is considered that you are not carrying on a business of rental properties. You derived rental income from less than five properties and only one for the whole year. The rental properties are leased on a long term basis as opposed to the short term holiday flats rented out by the taxpayer's in Case G10.

We acknowledge that you perform some of the activities required for the managing and maintenance of the properties. However, the undertaking of managing and maintenance, level of involvement, scale of activity and volume of operation in the activity is far less extensive than the tasks noted in Case G10. The circumstances surrounding the management and maintenance are similar to the owners noted in Case 26 which was not considered to be a business.

Having given consideration to the relative business indicators and the facts of your case, it is considered that you were not carrying on a business of leasing rental properties in the year ended 30 June 20YY.

Issue 2

Question 1

Summary

You did not sell an active asset. Assets cannot be active assets if the assets whose main use by the taxpayer is to derive rent. Paragraph 152-40(4)(e) of the ITAA 1997.

Detailed reasoning

A CGT asset will be an active asset for the purposes of the ITAA 1997 if it satisfies one of the positive tests set out subsection 152-40(1) of the ITAA 1997 and it is not excluded by one of the exceptions contained in subsection 152-40 of the ITAA 1997.

Positive test - Carrying on a business.

Under paragraph 152-40(1)(a) of the ITAA 1997 a CGT asset is an active asset (subject to exclusions that will be discussed below) if it is owned by a small business entity and is used or held ready for use by that small business entity in the course of carrying on a business.

The first issue to be resolved is whether or not you are carrying on a business. It has been determined in Issue 1 above that you are not carrying on a business of letting rental properties.

If the Commissioner is correct in his view that you are not carrying on a business, then you do not satisfy the positive business test set out in paragraph 152-40(1)(a) of the ITAA 1997.

However, for the purpose of completeness, the Commissioner will discuss the exception contained in paragraph 152-40(4)(e) as the Commissioner is also of the view that the main use to derive rent exception will preclude the sale of the rental property from qualifying as an active asset.

Exception - Main use to derive rent.

Paragraph 152-40(4)(e) of the ITAA 1997 provides that an asset whose main use in the course of carrying on the business is to derive rent, cannot be an active asset unless that main use for deriving rent is only temporary.

In the Advanced guide to capital gains tax concessions for small business published by the Australian Taxation Office the Commissioner states:

Whether an assets main use is to derive rent will depend on the particular circumstances of each case. The term rent has been described as referring to payments made by a tenant/lessee to a landlord/lessor for exclusive possession of the leased premises. As such, a key factor in determining whether an occupant of premises is a lessee paying rent is whether the occupier has a right to exclusive possession. If, for example, the premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to rent and the premises will not be an active asset. On the other hand, if the arrangement only allow the person to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are not likely to be rent.

Example

Rachael owns five investment properties which she rents to tenants under lease agreements granting exclusive possession. The lease terms vary from six months to two years. The properties are not active assets because they are mainly (only) used by Rachael to derive rent. It is irrelevant whether Rachael's activities constitute a business or not.

Factors that are relevant for determining whether an occupier has a right to exclusive possession include the degree of control retained by the owner and the extent of any services provided by the owner such as room cleaning, provision of meals, supply of linen and shared amenities.

The Commissioner has formed the view that even if you were held to be carrying on a rental property business, the rental properties will not qualify as active assets as the main use of the rental properties is to derive rent. The reasons for this are:

• Under the standard Tenancy Agreement, you grant each tenant exclusive possession of their individual rental property.

• You are not supplying any significant additional services to the tenants (such as room cleaning, meals, linen supply, etc.) but are rather carrying out activities that relate directly to your ownership of the rental properties.

The issue of whether a taxpayer's rental properties can be active assets when they are carrying on a business of letting rental properties was considered in Jakjoy Pty Ltd v FC of T [2013] AATA 526, (Jakjoy).

In Jakjoy the taxpayer was carrying on a business of leasing commercial properties. It was held that despite the fact the taxpayer was carrying on a business of leasing properties that the properties were not considered 'active assets' under section 152-40 of the ITAA 1997 and did not satisfy the 'active asset test' in section 152-35 of the ITAA 1997. Given the main or only use of the properties was to derive rent, the properties were excluded from being active assets under section 152-40(4)(e). This was regardless of the fact that the taxpayer's activities amounted to the carrying on of a business. It was affirmed that '….although it was common ground that the taxpayer was carrying on a business of renting properties, it did not automatically follow based on a clear reading of the text in section 152-40 of the ITAA 1997, that the properties the taxpayer used in carrying on its business were 'active assets' Indeed, those properties were expressly excluded from being 'active assets' by the exception in section 152-40(4)(e) of the ITAA 1997.